A reader writes, “I was wondering if you have written anything (or can write in the near future) about a comparison of portfolio rebalancing strategy – timed, percentage, cash flow based etc. I follow a directed cash flow based strategy to keep/maintain my asset allocation”.
“I change every SIP accordingly (I know it is too much effort, but I am ok with it since I have a small number of funds, and I do it via an app, and it takes hardly 5 minutes to change those amounts). But I wonder if it would be better to let the SIP run unchanged for some time and then rebalance by selling / reinvesting to achieve balance”.
First, let us get something out of the way about SIPs: We have always recommended that investors manually invest as much as they can each month (on any date!) without being tied to X or Y SIP amounts. Sure, SIP offers the benefits of automation, but wealth is built by maximising our investment and having done this (invest manually without SIPs) for the last 10+ years, I am confident it is the way to go.
It would take only a few minutes each month. There is nothing wrong with a SIP. We should push ourselves to invest more! If you want an automated set of instructions to make you “disciplined”, then I am afraid it won’t last. That said, portfolio rebalancing is a different ball game.
What is portfolio rebalancing? An asset allocation is the most important aspect of your portfolio. It tells you how much equity you hold and how much-fixed income. The desired asset allocation will balance risk and reward so that we have a chance of achieving a target corpus by a set date. This asset allocation is varied down the line to reduce risk in the portfolio by lowering equity exposure.
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So the first thing to keep in mind is that portfolio rebalancing is relevant only if we have done the above steps and are close to our target asset allocation. We shall assume that this is the case.
Suppose I allocate 60% of what I can invest each month to equity and 40% to fixed income. The asset allocation is 60:40. This will stay put because our investment values oscillate due to market forces.
Rebalancing is a process of resetting the portfolio back to the desired asset allocation. The universally accepted reset frequency is once a year. So after a year, if the desired asset allocation is 64% equity and 36% fixed income, then 4% of the equity should be sold and reinvested into fixed income. This comes with taxes and exit loads.
To minimise this, some investors wait for the deviation to be more than 5%. They will wait for the equity allocation to stray more than 65% or less than 55% and then initiate the rebalance.
What is the purpose of portfolio rebalancing? A higher equity allocation than desired means the markets have done well. So rebalancing moves some gains from equity to the safety of fixed income.
A lower equity allocation than desired means the markets have done poorly. So rebalancing here can be thought of as “buying the dip”.
In essence, rebalancing is selling a well-performing asset class and buying a relatively poor performing asset class to reduce volatility in the portfolio. For some data, see: What are the benefits of portfolio rebalancing?
Can I rebalance my portfolio by adjusting my SIP amounts? Young earners do this with small portfolios. They want portfolio management benefits but don’t want to pay tax on redemptions. But does it make sense?
Technically, this can restore asset allocation within desired levels unless the market zooms up or zooms down. And it can be done as long as the investments are increased at a rapid clip over the years.
However, it is a far from enjoyable task and can backfire. Suppose you invest Rs. 60 in equity and Rs. 40 in fixed income each month. After a year, the equity investment value is Rs. 1400. That is nearly double the total investments made so far. Say the fixed income value is Rs. 560.
So the equity allocation is now 72%. Even if you invest only in fixed income, it may take months for the allocation to drop close to 60%. If the market falls within this time (gradually, which is far more dangerous than suddenly!), you will achieve the rebalancing goal faster without paying taxes, but you would have also lost some of the gains made over the past year. You would have also lost precious equity investing time forever. Does that seem acceptable to you?
It certainly is not for me. The most comforting, the most rewarding movement in equity investing for me is not “seeing” those huge XIRR numbers each night but redeeming profits and pushing it (forever) to the safety of fixed income.
My son is about six years away from school. I would never advise any parent to hold 55% equity at this stage, but I do. The only reason for this is because I rebalance his future portfolio two times a year after two bull runs from Dec 2009. With more than enough locked up in safe debt to fund UG and some, it allows me to take more risk than one typically should. See: This useful feature of PPF deserves more attention!
So we think that this “adjusting SIP amounts to rebalance” is a normal process in an investor’s journey when his net worth is small. Gradually the opportunity cost of not booking profits or not buying the dip in time via regular rebalancing would be higher than the tax saved by changing investment amounts.
We advise the reader to replace his current strategy with “proper” rebalancing and maximising investments as per the target asset allocation. Remember, tax is the peanuts we toss to the government on our way to becoming multi-crorepatis.
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