Think Investor: Rebalancing goal-oriented investments


You should create Systematic Investment Plans (SIPs) for your stock and bond investments to achieve your life goals. Your SIPs for stock investments could be in exchange-traded funds (ETFs) or mutual funds, and your SIPs for bond investments could be in recurring bank deposits. After setting up a SIP, you may need to rebalance your portfolio annually. In this article, we discuss why realignment is important to achieve your life purpose. We also discuss how to rebalance your portfolio.

Annual adjustment

Asset allocation refers to the proportion of stock and bond investments you want in your portfolio to achieve a specific goal. This is a function of four factors – the time horizon for a life goal, the amount you want to accumulate to reach the goal, the amount you can save to reach that goal, and the expected return after return, adopted for stock and bond investments.

Suppose the time horizon for a life goal is 10 years and you want to accumulate 1 crore to reach the goal. Say you can save ₹50,000 per month. You need to earn a 9.5% compound annual return to accumulate the amount you want in 10 years. Let’s say the expected after-tax return on equity is 11% (pre-tax 12% with 10% capital gains tax) and the recurring deposit is 3.5% (pre-tax 5% with 30% income tax). Then your asset allocation needs to be 80% stocks and 20% bonds to achieve that goal.

Because your equity investments can have unrealized gains (losses) each year, your asset allocation at year-end could be different from 80/20. You need to adjust the equity portion to bring the asset allocation back to 80/20. This adjustment process is called rebalancing.

rebalancing rule

What happens when stock investments go up after you sell some shares in your ETF or mutual fund? Or what if stock investments fall after you decide not to rebalance? Either way, expose yourself to regret. Following a simple rebalancing rule will mitigate these regrets.

Now the after-tax (and before-tax) return on stocks and bonds is on an annualized basis since the required 9.5% yield is calculated on an accumulated basis. This means that in order to accumulate the desired amount at the end of a goal’s time horizon, you must keep 12% of unrealized gains in your stock investment each year. This also means that you can make gains of more than 12% per year by selling a corresponding number of shares in the fund. This reduces the risk of losing the excess returns if the market later falls.

You can keep those excess returns in a fixed deposit and use that amount to reinvest in stocks in years when the actual return is less than 12%; because such a deficit can add up over the years and lead to a larger deficit at the end of the time horizon for the goal in life.

To simplify this process, you can open a savings account (flexi-depot) with a bank where you keep a savings account to manage all your investments.

Capital gains tax applies when you sell ETF or mutual fund shares for rebalancing purposes. To defer capital gains tax, you can only elect to rebalance if the actual return is more than 13% one year from now, leaving a one percentage point margin over the expected return.

Note that rebalancing is the first of the two processes required to manage your stock investments over a lifetime goal time horizon. The second process typically involves reducing the stock allocation during the last five years of a lifetime goal time horizon. This could be the subject of a later discussion.

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

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