How to strike the right balance between equity and debt investments (2024)

By Dhirendra Kumar

For the last couple of editions of this column, we have discussed how much of your investment portfolio should be in equity and how much in fixed income. Almost every investor I know leans too much in one direction or the other. I know that I have personally done it at different times of my life, sometimes this way and sometimes that.

There are two reasons why this happens. One is that you do not know what you should be doing and the second is that you do not get around to doing it. Let’s focus on the first part first. What is asset rebalancing and why should you be doing it?

As we have seen in the last two weeks, you should have a certain part of your investment portfolio in equity and a certain part in debt. This ratio should stay fixed for years on end and should change only when the circ*mstances of your life change. I wouldn’t foresee it needing to change more than four or five times in an entire lifetime. When you start earning and saving, it should start at one level, then maybe when you get married and have kids. Then maybe when your kids are in their teens, then a few years before retirement and then a few years after retirement. Of course, mishaps do happen. People lose jobs, get seriously ill and so on. It could change at such times. The point is that the ideal (or target) asset allocation should not change every year. And yet, it does.

Almost every day, the real asset allocation of your investments shifts this way or that. Equity is always more volatile and yet generally has a higher base rate of returns than fixed income. This means that the two always have to be ‘rebalanced’. What this means is that if the actual balance has veered away from your desired one, you should shift money from one to the other in order to attain that percentage again.

When equity is growing faster than fixed income—which is what you would expect most of the time—you would periodically sell some equity investments and invest the money in fixed income so that the balance would be restored. When equity starts lagging, you periodically sell some of your fixed income and move it into equity. This implements beautifully the basic idea of booking profits and investing in the beaten down asset. Inevitably, things revert to a mean, which means that when equity starts lagging, you have taken out some of your profits into a safe asset.

It sounds complicated but in real life, the effect is almost magical. Volatility, the great problem of equity investing, is damped down and returns are hardly affected. But of course, this sounds like hard work to implement. Not just that, since the past couple of years, it has also not been very tax efficient. Earlier, selling out of equity investments that had been held for more than a year was tax-free. Now, there is a 10% tax on it. This means that switching in and out will reduce the money that you have for the future.

There are some simple ways to make this rebalancing easy and tax efficient. The first is that it does not have to be done that often. If your fixed income portion should ideally be one-third then there’s no need to start getting worried if it drops to 30%. Plus/minus 5-10 % is fine. Only when it approaches that level should you worry about rebalancing. Most of the time you can prevent it from hitting the boundaries by just increasing fresh investments in whichever side is lower, rather than doing any actual selling.

An even simpler method, very much suited to low-involvement mutual fund investing, has always been hybrid equity-debt funds. Since, the switching between equity and debt happens in the fund, there is no tax incidence until you actually withdraw the money to use it. Moreover, Sebi’s formalisation of the categories of mutual funds has meant that there are now a number of well-defined types of hybrid funds that are available to suit different types of equity-debt allocations.

But that’s a discussion for another day.

(The writer is CEO, Value Research)

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