A viewer on our YouTube channel asks, “I understand goal setting and rebalancing is the key. But how prudent is it to take money out of fixed income and buy equity to rebalance when markets are going down? Are we not increasing the risk of the entire portfolio by doing so? Can you please explain this concept?”
Rebalancing is resetting the asset allocation to minimise deviations from the target asset allocation. All investors have a portfolio, but only a few make informed decisions while assembling it. Most people suffer from shiny object syndrome and buy every new product in town. Rebalancing is a tertiary problem for them.
For beginners, a comprehensive three-part FAQ on portfolio rebalancing is available.
If you are interested in rebalancing, you need an asset allocation: how much am I currently investing in equity and debt? How much should I be investing in equity for my goal? How do I get there? How long will it take? After I get there, how am I going to vary my asset allocation?
For example. I have 20% equity and 80% debt. I need at least 40-50% equity for my goal. I need 3-4 years to increase equity allocation from 20% to 40%. After I get there, I will rebalance my portfolio each year to maintain the asset allocation at 40% equity and 60% debt. I will reduce the equity holding by a few percentage points every few years to ensure risk is reduced as the goal deadline is reduced. Absolute beginners can start with this seminar: Basics of portfolio construction: A guide for beginners.
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Suppose you have hit that target asset allocation of 40% equity and 60% debt; because of market fluctuations, it will not stay there. Every day it will fluctuate, and a reset is necessary either once a year or when the asset allocation deviates by, say, 5%. Suppose the equity allocation has become 45% and the debt allocation 55%, you need to withdraw 5% from your debt holdings and invest into equity or vice versa. Why do this? What is the benefit?
We have published a detailed backtest on the subject: What are the benefits of portfolio rebalancing? This is a summary.
- Rebalancing significantly reduces loss from a maximum. That is, the portfolio drawdown decreases.
- Rebalancing significantly reduces fluctuations in portfolio value (volatility).
- Rebalancing typically reduces the duration the portfolio was continuously underwater. That is below the previous maximum.
- Rebalancing between equity and fixed income sometimes results in more returns, and sometimes not. There is no way to determine this beforehand. Remember, the risk is in the journey. Returns are in hindsight. Rebalancing is a risk-reduction mechanism, not a return-enhancing mechanism. Higher or lower returns will depend on the particular return sequence we encounter.
- If the fixed-income instrument is market linked (e.g. a debt mutual fund), then the benefits of rebalancing are better than if the fixed-income instrument has a guaranteed income.
- Rebalancing need not be done each year. A reset when the deviation is 5% or more is sufficient and reduces tax and exit loads. See: The What, Why, How and When of Portfolio Rebalancing.
Rebalancing is difficult to implement behaviourally because it is counterintuitive. We must redeem funds from an asset class performing well and invest in another relatively underperforming asset class. This is so hard to do inspite of sufficient supporting evidence. Sometimes, hindsight is painful – Fearing tax, I didn’t rebalance my portfolio in Sep 2021 and now suffer higher losses!
Goal-based rebalancing to the rescue! The asset allocation in a professionally managed portfolio like a mutual fund or corporate portfolio typically does not change much. Here deviations from the target asset allocation must be reset as often as tax efficiency would allow.
Investor asset allocations should not remain the same (unless the corpus is much higher than the required sum). With the help of extensive backtesting, we have shown that a step-wise or continuous reduction in equity allocation well before the goal deadline ensures the investment corpus ends up close to the target corpus regardless of market conditions. We have automated this strategy in our robo-advisory tool.
Thus a goal-based investor with a focus on the target corpus need not worry about rebalancing from fixed income to equity in a down market provided,
- They have an equity reduction or variable asset allocation plan in place and stick to it.
- During portfolio reviews, their focus is on purchasing capacity of the corpus.
- They shift funds from equity to fixed income during bull markets if the asset allocation deviates by 5% or more.
Let me provide my situation as an example. So far, I have only rebalanced from equity to debt. Sometimes I have done it once a year, and sometimes twice a year without considering taxes or exit loads. The benefit is I now have enough assets to meet my goal in fixed income alone. This timely rebalancing has allowed me to take on more capital market risks. See: Why are you holding 55% equity with only six years left for your son to enter college? And At 46, why are you holding 60% equity for retirement? (I am not 48, which is still about 60%).
I could accomplish this without rebalancing from fixed income to equity. Goal-based investing thus differs significantly from conventional rules of portfolio management. As long as we can safely accumulate enough assets for a future purchase, we can bend the conventional rules to suit our requirements. However, to do so, we must first have a well-thought-out plan.
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