Whenever markets go into a tailspin, investors start thinking about asset allocation. But it should not be that way, because periodic rebalancing in a disciplined way controls the portfolio risk and ensures stability of returns in the long term. That’s not just theory–rebalancing actually works. Investors who rebalanced their portfolios in September 2024 when markets were zooming suffered much less when markets crashed in the following months.
But rebalancing is counter-intuitive because you are required to buy what is down in the dumps and sell what is doing well. Most investors don’t do this. In fact, going by the gargantuan Rs 30,350 crore net inflows into small and mid-cap equity funds in the first six months of 2024, investors were buying more and more of what was doing extremely well. It was a perfect recipe for the disaster that followed for they were adding more risk when they should have reduced it.
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You cannot control volatility, but you can control the risk in your investment portfolio. Any significant movement in an asset class should be seen as a nudge to rebalance the portfolio. Equity markets have slipped more than 15% from their September 2024 peak. For investors, this is a time to review their asset mix. Just like the bull run in 2024 increased the equity portion in the portfolio, the current downturn has decreased it.
The challenge is that just like many investors could not control their greed when markets were rising, most retail investors will not be able to overcome their fears in the current downturn.
The deep cut has shaken many investors, especially new ones who have never witnessed a downturn in their investment journey. Many are thinking of baling before their portfolio shrinks further. That would be disastrous, because they will turn notional losses into permanent ones.
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For some mutual fund investors, rebalancing is not required. Dynamic asset allocation funds are structured to buy low and sell high. When the PE of the chosen benchmark rises above a certain level, these funds reduce their allocation to equities. Conversely, when the market PE falls, they invest more in stocks. The results is not astonishing. Dynamic asset allocation funds have fallen 5.5% in the past three months compared to the 15-18% decline in equity fund categories.
Planning to rebalance your portfolio? Some investors tend to be obsessed with the tax implications of switching investments. Gains from debt funds bought before 1 April 2023 will get indexation benefit, but gains from investments made after that date will be added to the income and taxed at normal rates. Fixed deposits broken prematurely will get a lower rate of interest. Similarly, if stocks and equity mutual funds are sold within a year, there is a 20% tax on the capital gains made.
But one should look beyond tax and consider the psychological implications of rebalancing. Rebalancing helps grow wealth because it ensures that when markets crash and panic sets in, the rebalanced investor is more likely to remain invested. Panicking at that stage is a sureshot way to lose money.
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