Think Investor: Rebalancing goal-based investments

You should set up systematic investment plans (SIPs) on your equity and bond investments to achieve your life goals. Your SIPs for equity investments could be in exchange-traded funds (ETFs) or mutual funds, and your SIPs for bond investments could be in bank recurring deposits. After setting up an SIP, you may have to annually rebalance your portfolio. In this article, we discuss why rebalancing is important to achieve your life goal. We also discuss how to rebalance your portfolio.

Annual adjustment

Asset allocation refers to the proportion of equity and bond investments you decide to have in your portfolio to achieve a goal. This is a function of four factors — the time horizon for a life goal, the amount you want to accumulate to achieve the goal, the amount you can save to achieve this goal, and the expected post-return return assumed on equity and bond investments.

Suppose the time horizon for a life goal is 10 years and you want to accumulate one crore to achieve the goal. Also, suppose you can save ₹50,000 per month. You must earn a compounded annual return of 9.5% to accumulate the desired amount in 10 years. Assume the expected post-tax return on equity is 11% (pre-tax 12% with 10% capital gains tax) and on recurring deposit is 3.5% (pre-tax 5% with 30% income tax). Then, your asset allocation must be 80% equity and 20% bonds to achieve this goal.

Now, because your equity investments can carry unrealised gains (losses) every year, the asset allocation at the end of the year could be different from 80/20. You must adjust the proportion of equity to bring the asset allocation back to 80/20. This adjustment process is called as rebalancing.

Rebalancing rule

What if equity investments go up after you sell some units of your ETF or mutual fund? Or what if equity investments go down after you decided not to rebalance? Either way, you are exposing yourself to regret. Following a simple rule for rebalancing will moderate such regret.

Now, the post-tax (and pre-tax) return on equity and bonds are on a compounded annual basis as 9.5% required return is on a compounded basis. That means you must leave 12% of unrealised gains every year in your equity investment to accumulate the desired amount at the end of the time horizon for a goal. It also means you can take out gains greater than 12% per annum by selling appropriate number of units in the fund. This will reduce the risk of losing the excess returns if the market declines later.

You can keep such excess returns in a fixed deposit and use this amount to reinvest in equity in years when actual return is lower than 12%; for such shortfall can compounded over the years leading to a larger shortfall at the end of the time horizon for the life goal.

To simplify this process, you can open a savings-cum-deposit account (flexi deposit) in a bank where you operate a savings account to manage all your investments.

You will incur capital gains tax when you to sell ETF or mutual fund units for rebalancing purposes. To defer capital gains tax, you can decide to rebalance only if the actual return is greater than 13% in any year, leaving a margin of one percentage point over the expected return.

Note that rebalancing is the first of the two processes required to manage your equity investments through the time horizon for a life goal. The second process involves typically reducing equity allocation during the last five years of the time horizon for a life goal. That could be the subject of a later discussion.

(The author offers training programmes for individuals to manage their personal investments)