Asset allocation rebalancing: Here’s why it is essential

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The Covid-19 crisis has caused volatility in the stock market. In such times, often investors make rash decisions and invest based on fear. However, if you are a long term investor, keen to make gains over the long term, you should have an asset allocation strategy of your own and stick to it. Asset allocation means apportioning your investments to different asset classes such as stocks, bonds and gold.

“Asset allocation is the most important investment discipline to follow.  This has been proven to create the best value for investors in the long term,” said Anil Rego, founder and CEO, Right Horizons.

However, many a time investors stray away from their original asset allocation. Market moves also accentuate such drifts, especially in a year like 2020 when all the asset classes saw very high volatility. That necessitates a portfolio review and rebalancing of asset allocation. Here is how asset rebalancing works:

Importance of asset rebalancing

Asset rebalancing lets us get closer to the stated asset allocation we started with. When the asset prices move, they distort our asset allocation. For example, if you have started with an asset allocation with 60% equity, 35% bonds and 5% in gold in April 2020 and have seen stocks soaring and gold falling in the second half of the year it will distort your intended asset allocation. Asset rebalancing allows investors to set the things right by selling the asset class that has gained and investing the proceeds into the asset class which trails the stated asset allocation.

Rebalancing the asset allocation helps you to sell an overvalued asset and lets you buy an asset class which is out of favour or under-valued. What has not done well in the past, often tend to do well in future and the other way round. Asset rebalancing helps you to meaningfully benefit from changes in asset prices over long period of time.

When should you rebalance?

Sometimes asset prices spike and offer an opportunity to rebalance. But a disciplined approach is a must to capitalize on such quick moves. For example, you may decide on a quant-based rule – rebalance if there is a 20% move from the stated asset allocation. In the above stated asset allocation, if the equity allocation jumps to 72% (12 percentage point above the threshold of 60 percentage points), then in that case you should be rebalancing. Such number driven approach can help pocket quick moves which may be big but are short lived.

Don’t churn too often

Rebalancing involves carrying out buying and selling transactions. Rebalancing should ideally be done once in a year. If you do it too frequently then it may hurt. There are cost implications of the same. You may have to pay tax on your gains and there may be exit loads as well. Rebalancing too frequently may lead to excess of costs and thereby lowering of the benefit.

Rebalance makes asset allocation relevant. If not rebalanced from time to time, starting with an asset allocation won’t help you. Also from time to time, you have to take stock of your risk appetite and your financial goals. This would change in the asset allocation required at that time. This may differ from the stated asset allocation. If you implement the changes required, ignoring market noise, it may go a long way in achieving your financial goals.