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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Rebalancing - A great concept to beat your Emotions

One big problem with investing in equity/equity MFs is when to book profits and when to enter the markets. This problem is solved — very scientifically — by the concept of Portfolio Rebalancing.

Suppose you have a capital of Rs.10 lakhs and your risk appetite is moderate. So you invest Rs.5 lakhs each in equity and debt i.e. an equity-debt asset allocation of 50:50.

One year down the line, your debt part has grown to Rs.5.4 lakhs (assuming interest rate of 8% p.a.). The equity market has, in the meantime, hit a sweet spot and is up by 25% taking your equity investment to Rs.6.25 lakhs. Your portfolio is now valued at Rs.11.65 lakhs and the equity-debt asset allocation works out to 54:46.

Clearly, your portfolio has turned riskier. Thus, you need to de-risk it by selling some equity and buying debt. To come back to 50:50 allocation, you need to sell equity worth Rs.42,500 and shift this money to debt.

This is nothing but rebalancing.

Alternatively, it may also happen that the equity is down, while debt continues to deliver the same returns. Say the equity is down by 15%. Thus, while your debt investment would be up and worth Rs.5.4 lakhs, the equity portion would be down to Rs.4.25 lakhs. Accordingly, now your equity-debt asset allocation would work out to 44:56.

Your portfolio has, in this case, become somewhat conservative. Thus, you need to enhance your equity portfolio by selling debt. To come back to the original 50:50 asset allocation, you will now have to sell debt worth Rs.57,500 and buy equity.

As you may have observed, rebalancing tells you exactly when to sell/buy, what to sell/buy and how much to sell/buy; instead of looking at the Sensex and wondering — is it the right time to sell/buy and if so, how much to sell/buy.

A minor disturbance in the allocation is Ok. You don’t have to rebalance every other day. This will not only be too cumbersome but also tax inefficient. Therefore, unless some exceptional events happen which distort the ratio significantly, you can do rebalancing say once in 6 months to 1 year.

But make sure you stick to your calendar.

Apart from maintaining the portfolio balance, rebalancing has another excellent benefit to offer…it takes away emotions from your investments. It makes you:
> Sell when the markets are up (which you might otherwise not do due to Greed); and
> Buy when the markets are down (which you might otherwise not do due to Fear) 

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