You should set up a Systematic Investment Plan (SIP) on your equity and bond investments to achieve your life goals. Your SIPs for equity investments can be in exchange traded funds (ETFs) or mutual funds, and for bond investments your SIPs can be in bank recurring deposits. After setting up a SIP, you may need to rebalance your portfolio annually. In this article, we discuss why rebalancing is important for achieving your life goals. We also discuss how to rebalance your portfolio.
annual adjustment
Asset allocation refers to the proportion of equity and bond investments that you have decided in your portfolio to achieve the target. It is a function of four factors – the time horizon for a life goal, the amount you want to accumulate to achieve the goal, the amount you can save to achieve the goal, and the expected post-return Return assumed on equity and bond investments.
Let’s say the time frame for a life goal is 10 years and you want to deposit one crore to achieve the goal. Also, let’s say you can save ₹50,000 every month. You need to earn a compound annual return of 9.5% to accumulate the desired amount in 10 years. Assume that the expected post-tax return on equity is 11% (pre-tax 12%) with capital gains tax of 12% and 3.5% on recurring deposits (5% pre-tax with 30% income tax). Again, your asset allocation should be 80% equities and 20% bonds to achieve this goal.
Now, because your equity investments may carry unrealized gains (losses) every year, the asset allocation at the end of the year may differ from 80/20. To bring the asset allocation back to 80/20, you need to adjust the ratio to equity. This adjustment process is called rebalancing.
rebalancing rule
What if equity investments rise after selling some units of an ETF or mutual fund? Or what if the equity investment goes down after you decide not to rebalance? Either way, you’re exposing yourself to regret. Such regret can be minimized by following a simple rule for rebalancing.
Now, the after-tax (and pre-tax) return on equities and bonds is on a compounded annual basis as the 9.5% required return is on a compounded basis. This means you have to leave 12% of unrealized gains every year in your equity investments to accumulate the desired amount at the end of the time frame for the target. This also means that you can get more than 12% profit per annum by selling an appropriate number of units in the fund. This will reduce the risk of losing additional returns if the market turns down later.
You can keep such excess returns in a fixed deposit and use this amount to reinvest in equities in years when the actual return is less than 12%; Because such shortfalls can build up over the years leading to a big shortfall towards the end of the time frame for the life goal.
To simplify the process, you can open a savings-cum-deposit account (flexi deposit) with the bank where you operate a savings account to manage all your investments.
When you sell ETFs or mutual fund units to rebalance, you will be subject to capital gains tax. To defer capital gains tax, you can decide to rebalance only if the actual return exceeds 13% in any given year, leaving a difference of one percentage point on the expected return.
Note that rebalancing is the first of the two processes required to manage your equity investments through the time frame for life goals. The second process usually involves reducing the equity allocation during the last five years of the time frame for a life goal. This may be a matter of discussion later.
(The author provides training programs for individuals to manage their personal investments)