Optimising returns and mitigating risks: The risk-return trade off in portfolio rebalancing

Portfolio rebalancing is a crucial aspect of investing in mutual funds. It involves periodically reviewing one's investment portfolio and adjusting to align it with the original asset allocation. This can potentially help investors to capture upside returns while keeping risks within defined limits. In the Indian mutual fund industry, where thousands of new investors participate each year, understanding the risk-return dynamics of portfolio rebalancing is essential.

In this article, we discuss the key risks-return trade-offs in portfolio rebalancing for mutual fund investors and strategies to optimise the gains while managing downside risks.

• Table of contents

1. Understanding risks in portfolio rebalancing
2. Optimising return potential in portfolio rebalancing
3. The risk-return trade-off in portfolio rebalancing
4. Strategies for minimising risks & optimising return potential in portfolio rebalancing
5. Why portfolio rebalancing is important
6. A step-by-step guide to portfolio rebalancing
7. Advantages and limitations of portfolio rebalancing
8. When to rebalance your portfolio

Understanding risks in portfolio rebalancing

Equity markets are inherently volatile in the short term, and disproportionate exposure to equities can potentially pose a risk to portfolio values. Several factors can impact Indian equity markets and the rebalancing process. Let us take a look at the key factors.

Market risk: Sharp corrections in equity markets can lead to losses for funds heavy on equities during rebalancing. For example, the 2020 market crash impacted many investors' portfolios.

Liquidity risk: During periods of high volatility, mutual funds may impose redemption restrictions, exposing investors to liquidity risk. The 2020 crash saw such restrictions by some funds.

Interest rate risk: Changes in interest rates can impact debt funds' net asset values during rebalancing. Rising rates may potentially lead to capital losses for existing fixed-income instruments in a portfolio.

Company/sector-specific risk: Overexposure to particular stocks or sectors carries risk of losses from company or sector-specific events.

Thus, risks from market conditions, mutual funds' liquidity profiles, interest rate movements and company performances need to be accounted for while rebalancing. Diversification across asset classes, companies and sectors can help mitigate such risks.

Optimising return potential in portfolio rebalancing

While risks persist, a rebalanced portfolio also provides opportunities to enhance the return potential over the long term. Below are some pointers.

Capturing upsides: Rebalancing enforces systematic selling of past outperformers and buying of underperformers, thereby capturing some of the potential upsides.

Reducing volatility: A disciplined rebalanced portfolio maintains the intended asset allocation mix, improving the risk-adjusted return potential over time through lowered volatility.

Triggering capital gains: Over time, profit booking during periodic rebalancing results in long-term and short-term capital gains, optimising the post-tax returns for investors in applicable tax brackets.

Asset allocation gains: Sticking to the strategic asset allocation as markets fluctuate can potentially help investors to capture benefits from the varied cycles of different asset classes, thus enhancing the risk-adjusted return potential.

Reinvestment rates: Systematic investments/SIPs during market corrections can benefit from the rupee cost averaging effect, improving the portfolio return potential in the long run.

The risk-return trade-off in portfolio rebalancing

The central challenge in portfolio rebalancing is navigating the risk-return trade-off. Aggressive rebalancing to increase upside potential may raise volatility risks. Conversely, conservative rebalancing focused only on risk control may forego potentially available return opportunities. Striking a nuanced balance is important.

key considerations around the trade-off

• Understanding your individual's risk profile and time horizon
• Maintaining systematic discipline in rebalancing
• Using tactical opportunities judiciously
• Executing rebalancing gradually instead of making abrupt changes.

For example, a young investor can afford to take on relatively higher risk and to optimise the long-term return potential. In contrast, a retired investor relies more on risk control for steady cash flows and capital preservation. Gradual execution and diversification can help mitigate trade-offs in both scenarios.

Strategies for minimising risks and optimising return potential in portfolio rebalancing

Based on the above factors, here are some viable strategies mutual fund investors may adopt for successfully navigating the risk-return trade-offs of portfolio rebalancing.

• Define clearly your return expectations and risk appetite
• Maintain asset allocation discipline through periodic, systemic rebalancing
• Diversify widely across asset classes, sectors, market caps and companies
• Invest in high-quality equity and debt funds with long-term track records
• Consider flexi-cap funds for their tactical asset allocation abilities
• Rebalance gradually in volatile phases instead of attempting market timing
• Book profits selectively from past outperformers for locking gains
• Redeploy profits in undervalued segments/schemes for upside potential
• Leverage SIPs for participation in downward price movements
• Synchronise rebalancing with financial goals to maintain required returns
• Take expert advice if needed on navigating dynamic market conditions

Why portfolio rebalancing is important

Portfolio rebalancing is important for maintaining a balanced and effective investment strategy. Here's why it matters:

Maintaining your desired risk level: Asset allocation influences risk and return. Market fluctuations may cause this mix to drift, increasing risk. Rebalancing ensures your portfolio stays in line with your target allocation, preventing undue risk exposure.

Staying disciplined: Market volatility often triggers emotional decisions. Rebalancing provides a disciplined strategy, helping avoid impulsive actions like selling low or chasing overvalued assets.

Aligning with your goals: As your life circumstances and goals evolve, rebalancing ensures your portfolio matches your changing needs, such as reducing risk as retirement nears.

A step-by-step guide to portfolio rebalancing

Here's a step-by-step guide to portfolio rebalancing:

• Define your target asset allocation: Establish the percentage of your portfolio to allocate to each asset class based on your risk tolerance, investment goals, and time horizon. Consult with a financial advisor if needed.
• Review your current asset allocation: Check the composition of your portfolio and calculate the percentage of each asset class. This information is usually available on brokerage statements or investment dashboards.
• Identify deviations: Compare your current allocation to your target allocation. Identify asset classes that have deviated significantly.
• Determine the rebalancing strategy: Plan how to bring your portfolio back to the target allocation by selling overperforming assets and buying underperforming ones.
• Sell overweighted assets: Sell the assets that have exceeded their target allocation.
• Buy underweighted assets: Use proceeds from sales to purchase underperforming assets, bringing them back to their target allocation.

Advantages and limitations of portfolio rebalancing

Portfolio rebalancing is a key strategy for long-term investors, offering several advantages but also presenting some limitations.

Advantages of portfolio rebalancing:

• Disciplined investing: It reduces emotional decision-making, providing a structured approach to investment management.
• Aligns with financial goals: Rebalancing adjusts your portfolio to changing goals, such as reducing risk exposure closer to retirement.
• Potential for improved returns: By capitalizing on market fluctuations, rebalancing can enhance long-term performance.

Limitations of portfolio rebalancing:

Transaction costs: Rebalancing incurs transaction fees and costs, especially when done frequently, potentially reducing returns.

Tax implications: Selling assets in taxable accounts may trigger capital gains taxes, affecting overall returns.

Time and effort: Monitoring and adjusting your portfolio requires time and effort, and if you're uncomfortable, you may need professional help.

Missed opportunities: Rebalancing may cause you to sell high-performing assets in a rising market, missing further gains.

No guarantee of success: While it helps manage risk, rebalancing doesn’t guarantee higher returns or protection against losses.

When to rebalance your portfolio

Rebalancing your portfolio should be a thoughtful process. Here are the key times to consider rebalancing:

• Time-based rebalancing: Many advisors suggest rebalancing semi-annually. This offers a routine check-in and ensures your portfolio stays aligned with your goals. It helps maintain discipline and provides an opportunity to make necessary adjustments.
• Threshold-based rebalancing: Set a threshold (e.g., 5% or 10%) for when your asset allocation can drift before rebalancing. Again, consulting a financial advisor is important.
• Life events: Events like marriage, buying a home, job changes, or approaching retirement can affect your financial situation, necessitating a rebalance. These events often change your risk tolerance and financial priorities.
• Changes in financial goals: If your goals shift, like retiring early or pursuing a new career, rebalancing helps reflect these changes. It ensures your portfolio stays aligned with your current goals and risk tolerance.
• Market volatility: While it's important to avoid overreacting to short-term changes, extreme market volatility may require a rebalance to restore your desired risk level. Volatility can shift your asset allocation, increasing risk.

Conclusion

A disciplined, diversified and goal-based approach to portfolio rebalancing is imperative for mutual fund investors seeking optimal risk-adjusted returns over long periods of market volatility and uncertainty. Understanding risks, returns and mutual fund trade off in portfolio rebalancing can assist investors in making prudent investment decisions. By doing this effectively, investors can leverage the full potential of regular rebalancing practices for potentially meeting their life goals.

FAQs

What is the ideal frequency for rebalancing a portfolio?

The ideal frequency for rebalancing a portfolio is said to be every 3-6 months. Regular rebalancing ensures the asset allocation of the portfolio stays aligned with the investor's risk tolerance and investment objectives.

How can I determine my risk tolerance level?

You can start by considering your investment time horizon and to what extent short-term fluctuations in your portfolio would affect you emotionally. Answering questionnaires designed to assess your reaction to different investment outcomes can also provide insight into your risk tolerance. Speaking to a financial advisor and reflecting on your personal financial situation and goals can further help you identify the level of risk you are comfortable taking with your investments.

What are the benefits of portfolio rebalancing for an investor?

Portfolio rebalancing can help an investor maintain their desired risk-return profile and ensure the portfolio’s strategic asset allocation remains closely aligned with evolving financial goals over time. This can optimise the risk-return balance of their investments.

What is the principle of portfolio rebalancing?

Portfolio rebalancing involves periodically adjusting asset allocations to maintain a predetermined risk-return balance, ensuring investments remain aligned with an investor’s objectives and adapting to changing market conditions over time.

What is the main objective of portfolio rebalancing?

The primary objective of portfolio rebalancing is to maintain an investor’s intended risk-return profile by systematically realigning asset weights, maintaining diversification, and preventing excessive concentration as market values constantly fluctuate.

How do you rebalance a portfolio?

To rebalance a portfolio, periodically compare current allocations against target percentages, sell overweight assets, buy underweight ones, and maintain diversification. Consistent monitoring ensures alignment more effectively with long-term investment goals.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.