Last Updated on September 9, 2021 at 8:24 am
Piyush asks, “Dear Pattu Sir, You have mentioned several times the importance of portfolio rebalancing. Due to the marker recovery, my equity mutual fund portfolio allocation is now 75%. I want to reduce this to 70%. Can I do this by stopping my SIPS for a few months and invest it in fixed income? This way, I can rebalance the portfolio without paying tax.”
This is a standard newbie question. We all appreciate the theory behind portfolio rebalancing, but taxes scare us when it comes to practice. Before we answer it, let us start with the basics.
What is portfolio rebalancing? We assume a 10% or 12% return from equity. On a spreadsheet, our money grows each year by that assumed return. However, real life is quite different. One year you could get 90% from equity resulting in this: My net worth doubled in the last financial year thanks to patient investing!
Another year, you get a 30-40% loss resulting in this: My retirement equity MF portfolio return is 2.75% after 12 years! Rebalancing or an asset allocation reset is a simple way to reduce these fluctuations, sleep better and gradually reach your target corpus.
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Suppose your target equity allocation is 70% (to use Piyush’s situation). You start investing 70% of what you can in an equity mutual fund and 30% in fixed income. After one year, 75% of the total portfolio is in equity.
What do you do? Nothing? If the market falls, you will lose that 5% or more. What it if takes five years to recover back to 75%. I have spent a good decade and some trying to hit my goal of 60% equity – Rebalanced my retirement portfolio after 13Y, a crash & recovery!
Instead, I lock in the gains if I sell (redeem) 5% of equity mutual fund (wrt the full portfolio) and invest it into fixed income. I feel good about it. The benefits of rebalancing extend beyond a simple psychological boost.
As we have shown before – What are the benefits of portfolio rebalancing? – the portfolio fluctuates lesser (in terms of value and returns), the losses from an all-time high (aka drawdown) are lower, and the time spent in “red” (loss) is lesser. Sure, you have to pay some tax for it, but there is no free lunch. The benefits of rebalancing are far more than the money “lost” due to tax. Also, see: Forget tax and exit loads; this is why your portfolio should be rebalanced each year
At this point, some of you may be thinking, “all this is fine; what about the question asked by Piyush?”. Let us consider a simple example. Suppose my target asset allocation is 50% equity and 50% fixed income – this is a simple, common-sense based allocation that works well. – Will Benjamin Graham’s 50% Stocks 50% Bonds strategy work for India?
I start an Rs. 1000 a month SIP in ICICI Nifty Index fund direct plan and an Rs. 1000 a month SIP in ICICI Money Market Fund direct plan (click to read review). After three years, I realise that the asset allocations have drifted significantly.
The equity portion is now worth 57.8%, and the money market fund is worth 42.2%. So now I have two options:
A: Redeem an amount = 7.8% of the total portfolio from the equity fund and invest it in the money market fund. This is, of course, the standard way to rebalance a portfolio. I have to pay tax as applicable on the redemption. Yes, yes, one lakh of long term capital gain from equity is tax-free, but I am just considering an Rs. 1000 a month investment. Surely we must invest a lot more in real life! It is important to think big and think rich!
B: Stop the Nifty fund SIP and invest all the money (Rs. 2000) in the money market fund until the asset allocation naturally resets to 50:50. Here I will not pay any tax. Sounds great, does it not?
Not so fast. Consider what that 7.8% is worth. It is about Rs. 7,200 or at least seven months of SIP instalments. If the NIfty moves sideways for seven months, you can rest your asset allocation to 50:50 without pay taxing.
But why would the market behave the way you want? And that for seven long months? It could crash, and you could lose much of the 48% gains made thus far. It could zoom up more, and you would end up regretting stopping your SIPs, and the asset allocation would deviate much more than what it is today.
Option A one can use sparingly – that is, if the asset allocation deviates by 5%. How about if we use option B each year? Surely this will bring the time required to adjust the imbalance with investments.
True. This might work for the first few years. For example, a SIP of Rs. 10,000 each in the above two funds started a year back would result in an equity allocation of 54.6%. This represents an excess allocation of about Rs. 12,500. Most of the deviation can be resent by simply stopping the equity SIP for one month.
However, what if the market crashes within that one month? Would you not regret your decision? Think of the opposite situation. You invest an amount in an equity fund on, say, Monday morning. That evening, units are not allotted because the AMC has not yet received your money.
On Tuesday, the market falls by 5%, but you have not yet got an allotment. On Wednesday, another 5% fall, but the units get allotted only on Wednesday when there is a 6% recovery. Would you feel aggrieved or not? Would you not complain, crib, rant etc., that a good buying opportunity has been lost? Now, what if the same occurred after you decided not to sell?
Most of us would or at least feel bad about such an episode. So when you are sitting on considerable gains, why would you think of leaving it there fearing tax and think about adjusting investment to change asset allocation over a few months? How does it make sense!
Finally, suppose you continue the two Rs. 10,000 SIP for a few years and somehow managed to keep the asset allocation close to 50:50 one year ago. Suppose the portfolio was five lakhs in equity and five lakhs in fixed income in Sep 2020.
After a year, the equity allocation would be Rs. 7.6 lakhs (53.7%) and the fixed income Rs. 6.6 lakhs (46.3%). Rs. 52,000 (approx) needs to be shifted from equity to fixed income. This is five months SIP (one month’s instalment in the above example has become five now because the starting value of the portfolio was Rs. ten lakhs). So again, would you leave the equity gains alone for five months and risk a crash?
In summary, rebalancing has to be done by redeeming from a well-performing asset class and investing in a (relatively) underperforming asset class. This need not be done each year. You can have a 5% threshold for rebalancing. That is, unless the equity allocation is equal to or higher than 5% above or below your target equity allocation, you need not rebalance. All other methods will not reduce risk and will not work beyond the first couple of years. Do not fear taxes and leave the fate of your money in the hands of luck!
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