One of the severe side-effects of this wild ride has been that asset allocations are widely out of whack. There are investors who have rushed out of equity and then rushed back in a great hurry. Moreover, since the middle of last year, mid-and small-cap stocks have done well, always a sure sign of a raging bull run. Nothing wrong with that, that’s what smaller-company stocks do and that’s their utility to the investor. However, it does lead to a lot of equity portfolios becoming too heavily tilted towards such stocks, thereby increasing the volatility and the risk down the road.
At times like this, thinking back sanely to your asset allocation and trying to restore it by rebalancing seems like a foolish thing to do. That’s because asset rebalancing always (by definition) involves selling assets that have done better and leaning towards assets that have done worse, or at least less well. It goes against the instincts of investors and in fact, that’s exactly why it frequently gets ignored till it’s too late.
For a moment, let’s recap the basic concepts here and what the logic is, in simplified terms. One: Basically, there are two major types of financial investments, equity and fixed income (deposits, bonds etc). Two: Equity has higher potential gains and more risk, while fixed income has lower but less volatile gains. Depending on your preference, you should invest in equity and fixed income in a certain ratio. This ratio is called asset allocation. Three: Over time, equity and fixed income gain at different rates, thus changing the asset allocation away from what you want. Shifting money between the two to restore that allocation is called asset rebalancing. The same principle can also apply to different sub-types within assets. For example, within stocks, to small- vs mid- vs large-caps or even sectors.
Here’s why it works, and why investors are so resistant to the idea. When ‘A’ is growing faster than ‘B’ you would periodically sell some ‘A’ investments and invest the money in ‘B’ so that the balance would be restored. When ‘A’ starts lagging, you periodically sell some of your ‘B’ and move it into ‘A’. This beautifully implements the basic idea of booking profits and investing in the beaten-down asset. Inevitably, things revert to a mean, and that means that when one starts lagging, you have taken out some of your profits into the other. Substitute any asset class or subclass for A and B—the principle is the same. It’s obvious why this is a hard thing to do. Asset rebalancing always, without fail, involves quitting the very type of investment that is doing well.
However, success at investing is full of things that are difficult to do, in the sense that they are psychologically counterintuitive. Most investors learn the lesson after a couple of bad experiences. The lucky ones manage to do so without too high a cost.
(The writer is CEO, Value Research)
Also Read: Time to rebalance your portfolio now
