If diversification is about 'not keeping all eggs in the same basket', rebalancing is the realisation that 'what goes up, will come down'. Yes, investment portfolio management is all about simple common sense. In this post, I would like to revisit the topic of portfolio rebalancing and discuss what it is, why do it, and simple ways to do it.
I would like to thank Sunny Sachdeva for suggesting this topic, forcing me to reframe posts on rebalancing first published in May-June 2013 (links below). This is important for two reasons, (a) I have learnt a lot more in these three years and (b) I can probably write a lot better now than earlier.
What is portfolio rebalancing?
First, let us get a few things out of the way:
Rebalancing is redeeming from one asset class and reinvesting immediately in another. Rebalancing is not profit booking.
Rebalancing is not timing the market.
Rebalancing is not a method to get higher returns.
Yesterday we looked at how to build a diversified portfolio. The primary idea behind this and behind any successful investment strategy is asset allocation (% exposure to equity, fixed income, gold etc.).
There are many types of asset allocation strategies (more on that later), but I would like to stick to a simple plan: 60% equity and 40% fixed income.
However, as we keep investing and as the value of these asset classes increases or decreases, the asset allocation will deviate from the target allocation.
Rebalancing refers to the method by which we reset the asset allocation. There are many ways to do this too. Will discuss a simple method here. Other examples can be seen in the posts below.
We start with a portfolio with X% equity allocation and Y% fixed income. At the end of each year, the asset allocation is reset back to X:Y (will become clear with the example below).
Let equity exposure be 40% (for illustration) and fixed income exposure 60%. Suppose a lump sum of Rs. 10,000 was invested at the start of 2003, the value of the equity portfolio and fixed income folio (fixed 8% return for simplicity) will evolve in the following way.
Notice how much the equity allocation varies from 40% at the end of each year. The idea behind rebalancing is to reset it back to 40% at the start of each year.
Note the lower volatility in the rebalanced portfolio. This is the primary objective of rebalancing. It is purely accidental that for the given set of returns, rebalancing has resulted in a higher value at the end of the tenure. For the above data set, this is true for any equity allocation from 36% to 99%.
I can easily show you another return data set for which rebalancing lowers volatility but also lowers final portfolio value.
When I say volatility, I am also referring to psychological comfort or mental peace, if you will. If the equity folio has moved up 90%, a fall is inevitable. Rebalancing is a way to cushion your mind and folio against such a fall. Whether it will lead to more returns or not is neither certain nor necessary.
Practical considerations
A diversified portfolio is 'usually' built with asset classes that are poorly or negatively correlated with each other. For example, a long-term gilt fund and equity is one way to do it.
Under ideal circumstances, interest rates are increased just before the start of a bull run. This allows the gains made in long-term gilts or gilt funds to shifted to equity. As a bull run progress, inflation gradually increases and interest rates will also increase. Gilts would lose and the gains from equity can be shifted there.
Therefore, rebalancing is the process of shifting gains from an asset that has performed well to an asset that had done poorly but is expected to do well. This sounds easy to say, but quite hard to implement. Also, both asset classes can rally or crash at the same time.
I refer to this as two-way rebalancing and this is illustrated above, although the fixed income rate is fixed at 8%. Two-way rebalancing requires two poorly correlated volatile asset classes.
I generally prefer and recommend low volatile fixed income. For the simple reason, natural choices like PPF or EPF is available this way. If such fixed income is EPF of PPF, unconstrained withdrawals are not possible and only one-way rebalancing is typically possible. That is positive deviations from equity are shifted to fixed income. Negative deviations are ignored.
Positive deviations could have a threshold. That is, if equity allocation changes from 50% to 53%, do nothing. But if the difference increases by 5% or 10%, then and only then, rebalance.
I can use the benefit of hindsight to tell you what has worked. Does not mean such a strategy will work. If you like the idea of a lower portfolio volatility and peace of mind by shifting gains to fixed income or vice versa, rebalancing will be a good idea.
How about taxes and exit loads? This can easily be avoided by letting a portfolio grow for a couple years. Then withdrawals from equity funds will be free of tax and exit load (depending on fund structure).
Previous studies on rebalancing and portfolio management
Understanding Volatility of Investment Returns with a Portfolio Rebalancing Simulator
The What, Why, How and When of Portfolio Rebalancing With Calculators to Boot
Deciding on asset allocation for a financial goal
Asset allocation for long-term goals
Quantifying Portfolio Diversification – Part I
Portfolio Diversification with International Stocks
Portfolio Diversification: Correlation among Stock Sectors
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A question here. There are certain amounts of monthly investment that the retirement calculator suggests for all classes. But I see that EPF and PPF are more in % than the 70:30 ratio I have decided. However, over the next some years with aggressive equity investment I should be able to reach this target. So what should be done? Keep investing as per the schedule or increase equity or decrease debt to start off from the designated ratio right now?
If your asset allocation if off to being with, yes you keep investing more in equity until it balances out.
There are varied no. of strategies and opinions on Asset allocation and Diversification which can only be back tested and beyond any assertive prediction or even a forecast. In simple terms it is like the mix of hot and cold water one would prefer to take a shower, there can be various models, but ultimately it has to be qualitatively set by the one who takes the shower considering temperature, discharge & pattern of flow. It all depends on ones own comfort levels, more so if one experiences what relatively hotter water feels like. Likewise it applies in a similar fashion even to the optimum no. of funds to be maintained in a portfolio for ideal diversification leaving aside the administration issues. The real importance of a quality of fixed income portfolio has revealed itself in indifferent or depressed market spells of 1994-1999 2001-2003, 2008-2012 and those who had equity/ debt exposures during these periods appreciate it all the better in a real sense having burnt their fingers or have come out relatively less hurt. For a good amount of time select balanced funds have performed even better than reputed diversified equity funds. And more than the returns it is the consistency and amount of certainty that gives us investment comfort. The better an investor appreciates it rather than chasing performance, the better secured and certain would be his/her portfolio quality and performance. To my experience consistency and certainty of a portfolio mix to one own comfort levels matters above all.
I agree, but the problem is many do not have the confidence or conviction to define their own comfort levels.
Can the same objective not be achieved by simply maintaining your initial contribution of say, 40% or Rs. 4,000 in the above example as static throughout the period and any balance above this Rs. 4,000 be transferred to Fixed Income part. And similarly if in any year there is a shortfall due to loss in the equity portion, take the same amount out of fixed income and put it to equity portion.
How about putting investments for upcoming months in either equity/ debt to maintain the ratio rather than withdrawing ??
While in principle it is possible to change the investment allocation untile the portfolio asset allocation to back to where you want it,the time it may take is an issue.
I think it can be done with the same results.
The article does not explore this possibility. The article in its limited sense has taken one lump sum amount of Rs. 10,000 divided into equity of Rs. 4000 and debt of Rs. 6000.
While making fresh investments every month, if one is able to manoeuver fresh investment into two asset classes, it should serve the purpose with the limitation of the shortfall and fresh investment in each class.
"The article in its limited sense has taken one lump sum amount of ..." because systematic inflows have been explored before.
While in principle it is possible to change the investment allocation untile the portfolio asset allocation to back to where you want it,the time it may take is an issue.
While rebalancing is very good in principle and I know I should do it(annually), I have never been able to do it in practice. I have around 6 MFs across fund house and market caps and RDs (with monthly SIPs running) for last 5-6 years.
Mostly by end of year the equity portfolio has grown higher and needs rebalancing. But I feel its too much work to sell multiple MFs and move it to FD and end up not doing it.
Will like to know if you are able to do it successfully regularly and any particular strategy you follow ( i.e. Sell all MFs in equal proportions or sell the ones which has gone up the most ?)
Re-reading this article on a Sunday. You have mentioned here that you would suggest a yearly rebalancing and also not time the marketing. However if you see the Nifty 50 P/E ratio as of 3-Jun-2016, its 22.77 and slowly approaching 24. StableInvestor has done a study where he has surmised that based on historical data, the market bounces off after 24 P/E ratio. So shouldn't one start pulling back from equity at say 23.8 rather than wait for a year go go by? Your gains gathered till that point will vanish if the market tanks to 21, 20 or lower. Though, I think it will require more monitoring but if one is in sync with the market trends even on a weekly basis this can be done. But I wonder will such a monitoring be worth the returns?
It is not true that the market bounces off after reaching 24! See the Sensex PE data here: Will long-term equity investing always be successful?
If you wish to rebalance when a 'high' PE has been breached then that is fine.
Greetings Mr.Pattu,
Appreciate your contributions in investment education world.
When re-balancing, what is the criteria for redemption from existing funds?
For e.g. Equity -> Debt.
(1) Fund which has done well (book the profits)
(2) Fund which has not done well (Corrective action)
(3) Redemption is also in the same ratio as SIP contributions. i.e. If I am contributing to 3 funds in the ratio of 50-25-25. Redemption is also done in the same ratio 50-25-25
Any comments/thoughts would be great help.
Fund with higher Volatility may be switched from Equity to DEBT for Rebalancing
P.C.Sharma
Hi free fincal,
But selling units for rebalancing will affect the compounding over the long term.
how this is to be managed.
please guide.
Thanks
There is no compounding in the first place! Just growth which may or may not happen. And rebalancing manages that risk. Do not assume it will always grow!
I don't think selling units will affect the compounding effect. It will only affect the total amount gained but as a percentage compounding or CAGR will remain the same.
The selling will not affect the annualised returns from the entire portfolio too much. It will however reduce the returns of the individual asset class.
Thanks kamal for reply.
i will study about this.
thanks a lot.
CAGR return will not be affected. Only the absolute return will be affected because you have reduced or changed the invested corpus.
Yes, I stand corrected.
Thanks Pattu.
I wonder why Balanced Funds are still marketed as for newbie investors!!
As long as they buy something, what do they care!