Buying a few stocks or making a mutual fund portfolio of 4 funds is not the end of your job in investment portfolio management so as to deliver returns in a long run. If this job of portfolio management is left to financial planner, financial planners should be aware of and responsive towards the ever changing vicissitudes of both the external market and also the client’s own needs and circumstances. Through an illustrative example, we herein examine the impact that changing markets can have on an investor’s portfolio and the manner in which a competent financial advisor would respond to the same.
In principle, a typical financial plan drawn up by a professional financial advisor aims to do the following:
Step I – Understand a client’s specific needs
Step II – Customize an investment strategy
Step III – Allocate assets as per the plan
Step IV – Regularly portfolio monitoring and reallocate the funds if required
Often, most advisors are so focused on Step I to Step III but Step IV which involves portfolio monitoring and portfolio rebalancing, the portfolio always gets overlooked. Ongoing monitoring and updating the client with the performance of the investments and discussing the possibilities and needs for portfolio rebalancing are more than just good customer service. It is actually an integral part of financial portfolio management. Let us look at a hypothetical case to understand it better.
Saurabh Makhija has the following asset allocation done as a part of financial planning practice
Now let us imagine a scenario where there is a long term secular rise in equity markets which
- Doubles his equity portfolio in two years
- Medium Risk instruments like balanced funds gave him 60% returns in the same period of 2 years
- Low risk instruments like fixes deposits gave him 20% returns in two years (not taken 18% just for simpler calculations)
As a result of this, his new portfolio allocation would now be as follows
Given that the investment portfolio is supposed to indicate the risk profile of the investor, the implicit conclusion from the above is that the change in the market conditions has not only changed Saurabh’s asset allocation, but has also changed his basic risk profile! A low-medium risk portfolio with initial 50 % allocation to fixed income and 20 % to equities is now changed to medium–high risk portfolio with 40% allocation to fixed income and 27% to equities. So, how do we ensure that his risk profile does not change and the investment pyramid remains stable?
This is where portfolio rebalancing, also known as strategic asset allocation comes into play. Portfolio rebalancing is a process by which the initial asset mix of the client is maintained over time. In our case this would be done by redeeming the required amount from the risky assets and reinvesting in the low risk assets so as to achieve the same % allocation.
- We would take out 10 Lakhs from equity portfolio
- We would take out 5 Lakhs from medium risk balanced funds
- Invest this Rs 15 Lakhs in fixed deposits or any other low risk instrument
After rebalancing , Mr. Ram’s asset allocation would look like this
This also ensures that the client book profits regularly from the appreciated assets and invests in assets with low risk and thus able to rebalance his portfolio. One should follow this practice of portfolio rebalancing as a part of financial planning atleast once every year. You may use paid portfolio management softwares offered by MProfit and Perfios