Substantial increase or decrease in stock prices can, and certainly does, disrupt the proportion of asset classes which you require to meet your financial goals such as buying a house, or saving for retirement.
If the stock prices surge by 20 percent for one year, and rise further by 10 percent for the next year, the average return each year for two years would be 15 percent – a reasonably good rate. Now let us assume that the rate of interest jumps by 30 percent for one year and then declines by 10 percent the subsequent year, the average return for two years would, in that case, be 10 percent for each year.
In the second example, even though the prices surged at a higher rate in the beginning, the substantial gains were wiped out in the following year.
In a hyper volatile market scenario, it is difficult to predict how the market will behave. When the stocks have risen substantially, it won’t take long before the profits are wiped out. And conversely, when the stocks fall, it won’t take long before the losses are recouped with market gains.
So, some experts suggest that it is advisable to rebalance the portfolio from time to time rather than waiting for the right time to make a killing. Rebalancing of the portfolio implies altering your allocation to equity and fixed income instruments after substantial market rise or fall.
What is rebalancing your portfolio?
It is the process through which you change the weightage of assets in your portfolio. Under rebalancing of the portfolio, you buy or sell securities to match the desired ratio of different assets in the portfolio.
As the market fluctuates, it is common that the original ratio in which different asset classes were bought would change. To rebalance the portfolio, some asset classes might have to be bought and some sold to bring the ratio back to original. It is vital to note that while doing so, some tax would accrue.
Let us assume that an investor decided to keep the ratio of equity and bonds as 70: 30. You expect the equity to give you consistent growth of 10 percent per annum but it rose by 20 percent. In this case, the actual allocation to equity must have risen vis-à-vis bonds, which means the overall proportion of equity, now, would be more than 70, and debt allocation less than 30.
As per the principle of rebalancing, some portions of equity need to be sold off to bring the ratio back to 70:30, which you kept at the outset.
In summary, the portfolio might have to be rebalanced if you want to book some of the profits, and prevent the profits getting wiped out during volatility. However, some investors stick to wait and watch strategy to maximise their gains, instead of booking the profits because they believe that a bull run is still on. But if you don’t want to risk losing the gains, then rebalancing can be an alternative which will ensure that you keep pocketing in gains from time to time.