What exactly do you understand by portfolio re-allocation? Once you have created your investment portfolio, there are quite a few strong reasons to re-allocate or rebalance your portfolio. It could have to do with the performance of certain specific asset classes or perhaps with a specific category of stocks or bonds. The need to rebalance could also arise when macro situation changes with respect to inflation expectations and interest rate projections. Asset class performance could also be a key reason for portfolio re-allocation like when equity or debt has outperformed and valuations are a concern. Finally, asset re-allocation is called for when new needs arise or your risk appetite either sharply increases or reduces. The core thing to understand here is the safeguards. Let us focus on some key mistakes to avoid when you re-allocate your portfolio..
Robots are great, but human intervention is a must
The big story these days is robo advisory. Here is a high-end computer machine that studies mountains of data about you and decides what is your appropriate risk and return matrix. Based on that, it churns out the right allocation and asset mix for you. That is good because more the data points you consider, the closer you are likely to reflect the real situation. But, as we all know the real life situation can never be perfectly simulated on the computer. There is an element of subjectivity and therefore there is that element of human discretion that you need to exercise, irrespective of what the algorithm says. Of course, robo advisors are still great starting points for asset allocation and asset re-allocation. But not bringing in human judgement into the process will be wrong!
Getting too rigid about your long term financial plan
We typically start off with our long term financial plan as the starting point. Once the long term financial plan is in place, the next step is to build your portfolio around that. The problem is that at times we tend to become too rigid about our approach to our financial plan. Remember, you financial plan is also made on the basis of certain assumptions. For example, you may have made an assumption of 6% inflation over 20 years. At the end of 5 years you may realize that the actual average inflation is likely to be much lower around 3%. That will require a tweak to your investment portfolio but more important you will also have to change the assumptions of your financial plan.
When re-allocation is driven by personal likes and dislikes
This is nothing abnormal. We all have our personal preferences for certain business groups, certain sectors. Like it or not, that does to an extent influence our decision making process. What is important is that these personal tastes should not come in the way of your portfolio re-allocation. That defeats the basic purpose of portfolio re-allocation, which is supposed to be as objective as possible. Most of all, avoid falling in love with the stocks or funds that you hold!
Being too fickle minded with respect to portfolio re-allocation
Remember, portfolio re-allocation is a serious exercise. So your decision to re-allocate your portfolio needs to be thought through. Portfolio reallocation has costs in terms of statutory costs, tax costs and opportunity costs. If you keep changing your re-allocation logic time and again, you do not add value. Decide on the time-line of reallocation and any intermediate reallocation should only be undertaken if the situation seriously demands.
Trying to make drastic changes without expert support
You start your financial planning journey with an expert advisor. Make it a point to involve your advisor when you are re-allocating. The advisor will be in a position to bring in a broader perspective as they deal with multiple clients. Also, reallocation has long term return and risk implications for your portfolio which you are eventually using to meet your long term goals. An expert advisor not only brings in the market expertise and breadth of understanding but also provides an outside perspective which can make the entire exercise a lot more objective.
Worrying about the losers and not about the winners
Normally, many of us tend to mistake portfolio re-allocation with weeding out the losers. Be it stock underperformers or a mutual fund laggard; that is where we focus on while reallocating our portfolios. The bigger, and perhaps, the more important challenge is to weed out the winners. After all, profit is what you book and all else is book-profit. Your reallocation should not only consider the laggards but also where profits can be taken out of winners and re-allocated to other asset classes.
Ignoring tax impact of re-allocation
Ignoring taxes is the cardinal sin in portfolio re-allocation. When you re-allocate your portfolio, there are tax implications in terms of long term and short term capital gains. Also, long term capital losses on equity cannot be set off or carried forward. All these factors add to the opportunity cost of portfolio reallocation. Therefore, your decision to reallocate your portfolio should always be based on post-tax analysis
The most important aspect about portfolio re-allocation is that it needs to be backed by expert advice and must include an important element of human judgement. Above all, don’t ignore the tax effect and the opportunity cost effect when you look at portfolio reallocation.