The importance of portfolio rebalancing

Over a long period of time, the growth of an investor’s investment portfolio, if left unchecked, may leave the portfolio to be overly exposed to risky assets.

In some cases, it may be under- exposed to risk assets which would have helped them grow their wealth.

In the context of unit trust funds, during market rallies, equity fund growth typically outpaces the growth in bond funds. Assuming the bul l period continues, equity fund’s portion in the overall portfolio will continue to grow larger, and larger, over time.

For a moderate risk investor, his portfolio could grow to the extent that an original 40/60 mix in Equity and Bonds eventually becomes a 80/20 mix in Equity and Bonds.

Putting the percentages into perspective with this example: The investor started with an original set- up of a RM100k investment portfolio with 40 per cent ( RM40,000) invested in Equity and 60 per cent ( RM60,000) into Bonds.

As 10 years went by and the bull market continued, his wealth burgeoned. His original investment grew to RM400,000; out of that, 80 per cent ( RM320,000) is now in equity while 20 per cent ( RM80,000) is in bonds – this represents the 80/20 mix in equity and bonds. The Perils rebalancing

The portfolio which is now 80 per cent invested in equity will definitely see its fair share of price swings. The now equityheavy portfolio exposes him to market gyrations that he may not be comfortable with. After all, he originally signed up for a 40 per cent equity and 60 per cent bonds.

Furthermore, unbalanced portfolios usually have their highest allocation to equity funds at market peaks. What follows after a dizzying rise can be a steep drop in prices before the next recovery kicks in. In other words, unbalanced portfolios are usually at their most vulnerable when markets turn for the worse. of not How does rebalancing works?

What the investor should have done is to sell some assets that have risen in value and use the proceeds to buy some of those that had declined.

By definition, rebalancing is a process where the portfolio will undergo some selling or buying in certain funds in order to re- align them back to their original allocation.

This means that if your original portfolio allocation is 30/70 in equity and bonds, and say, equity prices have gone up (which tilts the new allocation to 40/60), you sell the extra in equity and buy bonds until your overall allocation goes back to the initial 30/70. Conclusion

There are two implications t owa r d s implement i n g portfolio rebalancing. Firstly, it is a disciplined strategy. Rebalancing removes the emotional aspects from your investment making decision as the selling and buying decisions are triggered by predetermined factors eg: time- based ( every quarterly, annually etc) or target- based (if equity portion crosses a certain percentage of portfolio) .

Secondly, the portfolio will experience reduced volatility. Remember the unbalanced por t fol io above? It wil l inevitably capture more of the volati lities inherent ly present in equities as the more aggressive portion takes over the entire portfolio.

For the more risk- averse investors, that could wel l mean many sleepless nights. On the other hand, a portfolio that has 30 per cent allocated in equity, means the overall portfolio will only capture correspondingly 30 per cent of the equities’ volatility. A frequent rebalancing ensures the portfolio sticks close to its original allocation

Although many associate rebalancing as merely a form of risk control, we think of it as a path to more sustainable long term returns. Not only does it enable you to exercise some prudence by taking some money off the table when equity prices are high, if the rebalancing period coincides with a market sell- off, it will al low you buy equities at lower levels. Rebalancing is in essence, practising buying low and selling high.

Reba la ncing does not necessarily provide a boost to overal l returns. More importantly, it ensures that the portfolio remains diversified and in line with the investor’s original allocation – potentially offering him better peace of mind.

Areca Capital is a niche Malaysian fund management company. We are a firm believer in the advisory- based approach towards investing. We help our clients, who range from individuals to corporates, family and private trusts, foundations and other institution to achieve consistent risk- adjusted returns over the long term. For any enquiries, you may contact us at 0379563111 or by email: invest@ arecacapital.com