A reader says, “I have a query in portfolio rebalancing. When we are moving excess funds from equity to debt (based on asset allocation), normally from which asset, i.e. top performing or laggard fund, do we need to move? All funds in the portfolio are entered after considering all aspects, but given market volatility, few funds will be lagging others”.
“In many articles, you have mentioned that it depends on the situation, but how do you approach this situation when you do rebalancing? What is your thought process? I remember you have/had invested in QLTE and PPFAS, so when you rebalanced recently, which one did you liquidate, and what was your reasoning/logic? You may choose not to answer QLTE vs PPFAS. I just wanted to know the thought process”.
What is portfolio rebalancing? Asset allocation is the most crucial aspect of your portfolio. It tells you how much equity you hold and how much-fixed income you have. The desired asset allocation will balance risk and reward so that we can achieve a target corpus by a set date. This asset allocation is varied down the line to reduce risk in the portfolio by lowering equity exposure.
Suppose I allocate 60% of what I can invest monthly to equity and 40% to fixed income. The asset allocation is 60:40. This will stay put because our investment values oscillate due to market forces.
Rebalancing is a process of resetting the portfolio back to the desired asset allocation. The universally accepted reset frequency is once a year. So after a year, if the desired asset allocation is 64% equity and 36% fixed income, 4% of the equity should be sold and reinvested into fixed income. This comes with taxes and exit loads.
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To minimise this, some investors wait for the deviation to be more than 5%. They will wait for the equity allocation to stray more than 65% or less than 55% and initiate the rebalance.
What is the purpose of portfolio rebalancing? A higher equity allocation than desired means the markets have done well. So rebalancing moves some gains from equity to the safety of fixed income. A lower equity allocation than desired means the markets have done poorly. So rebalancing here can be thought of as “buying the dip”.
In essence, rebalancing is selling a well-performing asset class and buying a relatively poor-performing asset class to reduce volatility in the portfolio. For some data, see: What are the benefits of portfolio rebalancing?
For beginners, a comprehensive three-part FAQ on portfolio rebalancing is available.
Let us address the reader’s question with that out of the way. The primary objective is resetting the asset allocation to the target allocation. Decluttering the portfolio (eliminating funds or reducing their weightage) and/or lowering tax incidence are secondary objectives.
Since the primary objective is clear, we can decide what to do by looking at the holdings.
- If any fund is in “red”, that is an obvious sell as it would not lead to any tax. However, this is unlikely, as one only wishes to rebalance from equity to fixed income during or after a bull run. Almost all funds would have gained something by then.
- A fund you would like to eliminate (even if it is a good performer) because of extensive portfolio overlap with other holdings (similar category, etc.) could be sold.
- Holding on to good performers and selling underperformers during a rebalance is always tempting. I don’t see anything wrong with it, and I have done it a few times. For example, I have never sold from PPFAS FLexicap. I have sold Quantum Long Term Value Fund partially because it was underperforming and because I wanted to lower its exposure. I still hold a fair chunk of the Quantum Fund because I only sold to the extent necessary for the rebalance.
- On other occasions, for my son’s portfolio, I have sold a bigger chunk of an underperformed and a smaller chunk of an outperformer.
- I have seen investors hesitant to sell an outperformer expecting more gains and delayed rebalancing. Or they are worried about taxes – both can be big mistakes. Also see: Fearing tax, I didn’t rebalance my portfolio in Sep 2021 and now suffer higher losses!
So the answer to “Which should I sell to rebalance? Top performer or bottom performer?” is you can sell one or the other or a bit of both as long as the action meets the desired result – a reset asset allocation. While it is human nature to hold onto winners for as long as possible, they should be sold as necessary to align with the stipulated asset allocation schedule, as that is the top priority.