One of the serious side-effects of this wild ride is that asset allocation is largely useless. There are investors who have exited equities and then came back very quickly. Moreover, since the middle of last year, mid-cap and small-cap stocks have performed well, always a sure sign of a raging bull run. There is nothing wrong with this, this is what the shares of small companies do and that is their utility to the investor. However, this causes a lot of equity portfolios to lean heavily toward such stocks, leading to increased volatility and risk down the road.
At such times, it seems foolish to try to restore it by rebalancing and thinking about your asset allocation. This is because asset rebalancing always (by definition) involves selling off assets that have performed better and leaning towards assets that have performed poorly, or at least did well. This goes against the instincts of investors and in fact, is the reason why it is often ignored until it is too late.
For a moment, let’s revisit the basic concepts here and what is logic in simpler terms. A: Basically, there are two major types of financial investments, equity and fixed income (deposits, bonds etc.). Two: Equities have higher potential returns and higher risk, while fixed income has lower but less volatile returns. 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 accrue at different rates, thus shifting the asset allocation away from what you want. Moving money between the two to restore that allocation is called asset rebalancing. The same principle can also apply to different subtypes within the property. For example, within stocks, small- versus mid- versus large-cap 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 will periodically sell some ‘A’ investments and invest money in ‘B’ to restore the balance. When ‘A’ starts to lag, you periodically sell some of your ‘B’ and transfer it to ‘A’. It beautifully implements the basic idea of ​​booking profits and investing in beaten assets. Essentially, things go back to one mean, and that means when one starts to lag, you’ve taken some of your advantage into the other. Substitute any asset class or subclass for A and B—the principle is the same. It is clear why this is difficult to do. asset rebalancing always, without fail, involves omitting many kinds Investment that’s doing well.
However, success in investing is fraught with things that are difficult to do, in the sense that they are psychologically counterproductive. Most investors learn a lesson after a few bad experiences. The lucky ones manage to do this without costing too much.
(The writer is CEO, Value Research)
Read also: Now is the time to rebalance your portfolio