Optimising returns and mitigating risks: The risk-return trade off in portfolio rebalancing

Portfolio rebalancing is a crucial aspect of investing in mutual funds. It involves periodically reviewing one's investment portfolio and adjusting to align it with the original asset allocation. This can potentially help investors to capture upside returns while keeping risks within defined limits. In the Indian mutual fund industry, where thousands of new investors participate each year, understanding the risk-return dynamics of portfolio rebalancing is essential.

In this article, we discuss the key risks-return trade-offs in portfolio rebalancing for mutual fund investors and strategies to optimise the gains while managing downside risks.

• Table of contents

1. What is risk-return trade-off?
2. Understanding risks in portfolio rebalancing
3. Optimising return potential in portfolio rebalancing
4. The risk-return trade-off in portfolio rebalancing
5. Strategies for minimising risks & optimising return potential in portfolio rebalancing

What is risk-return trade-off?

The risk-return trade-off is the concept that higher potential returns typically come with higher risks. Investors must therefore balance their desire for returns against their ability to tolerate losses. For example, equities have the potential to offer higher returns over time but are more volatile, while bonds provide lower, relatively stable returns with less risk.

Investors, therefore, need to make a choice between risk and return while investing. Factors like financial goals, investment horizon, and risk tolerance play a key role in this trade-off. Younger investors may take on more risk for growth potential, while those nearing their goals may prioritise relative stability. Understanding the trade-off helps create a portfolio aligned with individual objectives and reduces chances of financial stress.

Understanding risks in portfolio rebalancing

Equity markets are inherently volatile in the short term, and disproportionate exposure to equities can potentially pose a risk to portfolio values. Several factors can impact Indian equity markets and the rebalancing process. Let us take a look at the key factors.

Market risk: Sharp corrections in equity markets can lead to losses for funds heavy on equities during rebalancing. For example, the 2020 market crash impacted many investors' portfolios.

Liquidity risk: During periods of high volatility, mutual funds may impose redemption restrictions, exposing investors to liquidity risk. The 2020 crash saw such restrictions by some funds.

Interest rate risk: Changes in interest rates can impact debt funds' net asset values during rebalancing. Rising rates may potentially lead to capital losses for existing fixed-income instruments in a portfolio.

Company/sector-specific risk: Overexposure to particular stocks or sectors carries risk of losses from company or sector-specific events.

Thus, risks from market conditions, mutual funds' liquidity profiles, interest rate movements and company performances need to be accounted for while rebalancing. Diversification across asset classes, companies and sectors can help mitigate such risks.

Optimising return potential in portfolio rebalancing

While risks persist, a rebalanced portfolio also provides opportunities to enhance the return potential over the long term. Below are some pointers.

Capturing upsides: Rebalancing enforces systematic selling of past outperformers and buying of underperformers, thereby capturing some of the potential upsides.

Reducing volatility: A disciplined rebalanced portfolio maintains the intended asset allocation mix, improving the risk-adjusted return potential over time through lowered volatility.

Triggering capital gains: Over time, profit booking during periodic rebalancing results in long-term and short-term capital gains, optimising the post-tax returns for investors in applicable tax brackets.

Asset allocation gains: Sticking to the strategic asset allocation as markets fluctuate can potentially help investors to capture benefits from the varied cycles of different asset classes, thus enhancing the risk-adjusted return potential.

Reinvestment rates: Systematic investments/SIPs during market corrections can benefit from the rupee cost averaging effect, improving the portfolio return potential in the long run.

The risk-return trade-off in portfolio rebalancing

The central challenge in portfolio rebalancing is navigating the risk-return trade-off. Aggressive rebalancing to increase upside potential may raise volatility risks. Conversely, conservative rebalancing focused only on risk control may forego potentially available return opportunities. Striking a nuanced balance is important.

Some key considerations around the trade-off include

• Understanding your individual's risk profile and time horizon
• Maintaining systematic discipline in rebalancing
• Using tactical opportunities judiciously
• Executing rebalancing gradually instead of making abrupt changes.

For example, a young investor can afford to take on relatively higher risk and to optimise the long-term return potential. In contrast, a retired investor relies more on risk control for steady cash flows and capital preservation. Gradual execution and diversification can help mitigate trade-offs in both scenarios.

Strategies for minimising risks & optimising return potential in portfolio rebalancing

Based on the above factors, here are some viable strategies mutual fund investors may adopt for successfully navigating the risk-return trade-offs of portfolio rebalancing.

• Define clearly your return expectations and risk appetite
• Maintain asset allocation discipline through periodic, systemic rebalancing
• Diversify widely across asset classes, sectors, market caps and companies
• Invest in high-quality equity and debt funds with long-term track records
• Consider flexi-cap funds for their tactical asset allocation abilities
• Rebalance gradually in volatile phases instead of attempting market timing
• Book profits selectively from past outperformers for locking gains
• Redeploy profits in undervalued segments/schemes for upside potential
• Leverage SIPs for participation in downward price movements
• Synchronise rebalancing with financial goals to maintain required returns
• Take expert advice if needed on navigating dynamic market conditions

Conclusion

A disciplined, diversified and goal-based approach to portfolio rebalancing is imperative for mutual fund investors seeking optimal risk-adjusted returns over long periods of market volatility and uncertainty. Understanding risks, returns and mutual fund trade off in portfolio rebalancing can assist investors in making prudent investment decisions. By doing this effectively, investors can leverage the full potential of regular rebalancing practices for potentially meeting their life goals.

FAQs

What is the ideal frequency for rebalancing a portfolio?

The ideal frequency for rebalancing a portfolio is said to be every 3-6 months. Regular rebalancing ensures the asset allocation of the portfolio stays aligned with the investor's risk tolerance and investment objectives.

How can I determine my risk tolerance level?

You can start by considering your investment time horizon and to what extent short-term fluctuations in your portfolio would affect you emotionally. Answering questionnaires designed to assess your reaction to different investment outcomes can also provide insight into your risk tolerance. Speaking to a financial advisor and reflecting on your personal financial situation and goals can further help you identify the level of risk you are comfortable taking with your investments.

What is the risk-return trade-off definition?

The risk-return trade-off is a fundamental investment principle that posits a positive correlation between risk and potential return. This means that higher potential returns are typically associated with higher levels of risk. Conversely, lower-risk investments tend to offer lower potential returns. Investors must carefully balance their risk tolerance with their desired level of return when making investment decisions.

How does risk return trade-off affect your decision?

It is essential for investors to grasp the concept of risk-return trade off so that they can plan their investment strategy according to their goals and risk appetite. Investors who are not comfortable with risk will need to suit conservative investment avenues, while understanding that they may not offer significant return potential in the long term, and vice versa. This can help set more realistic expectations

Why is there a trade-off between risk and return?

The risk-return trade-off exists due to fundamental economic and market principles. Investors demand higher potential returns as compensation for taking on greater uncertainty and potential for loss. This relationship stems from the basic economic concept that increased risk requires additional reward to motivate investors to accept higher levels of potential financial volatility and potential capital erosion.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.