A reader asks, “If you started investing one year and four months back with 60 -40 equity-debt, Its current value is 59 – 41. Should you rebalance now or wait for the further difference?”
What is portfolio rebalancing? Asset allocation is the most important aspect of your portfolio. It tells you how much equity you hold and how much-fixed income you have. The desired asset allocation will balance risk and reward to achieve 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.
So the first thing to remember 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.
How often should a portfolio be rebalanced? The primary consideration is, what is the plan to reduce risk in the portfolio? Or in other words, assuming a portfolio starts with 60% equity as the reader’s, how should the equity allocation be reduced to ensure the corpus accumulated to close to that required?
We have shown that a continuous or step-wise reduction in equity well before the goal deadline is an excellent way to reduce the impact of a poor sequence of returns and achieve our goals regardless of market conditions. See, for example: How to systematically reduce risk in your investment portfolio. This is implemented in our robo-advisory tool.
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Therfore this progressive reduction in equity is also a form of portfolio rebalancing. Assuming such a plan is in place, we only need to ask what to do in the years when the target asset allocation is fixed.
There are two choices:
- Rebalance each year regardless of market conditions.
- Rebalance when the asset allocation exceeds the target by 5% or more. This is known as threshold rebalancing.
Threshold Rebalancing: Say you start with (equity) 50:50 and rebalance the portfolio back to 50:50 only if the equity component changes (increase or decrease) by 5%. After year one, if the portfolio reads 52:48, you do nothing. It reads 45:55; rebalance back to 50:50. If it reads 56:44 or 40:60, you rebalance back to 50:50.
Threshold rebalancing reduces tax incidence, and our studies show that it is just as good as annual rebalancing. See The What, Why, How and When of Portfolio Rebalancing With Calculators to Boot.
Therefore we recommend that the reader first develop a risk reduction plan, device how long we wish to continue with 60% equity and then rebalance only if the deviation is 5% or more.
Over the years, readers have asked us several questions on portfolio rebalancing. We have compiled them in this three-part FAQ.