Portfolio Rebalancing: We answer frequent questions investors worry about (part 1)

Published: November 13, 2020 at 11:30 am

Last Updated on February 12, 2022 at 6:15 pm

In this article, we answer frequently asked question on portfolio rebalancing. Theoretically, it is easy to understand rebalancing but when it comes to practical implementation, investors have so many questions and mental blocks.

The idea behind rebalancing is fairly simple and one that we have dealt before with examples multiple times:  it is a process of resetting asset allocation. If you start investing with 50% equity and 50% fixed income, the weights will fluctuate on daily basis due to market movements.

Rebalancing is when we reset these weights back to the levels we desire. For example, if equity allocation has increased by 55% after one year, we sell some holdings and invest it into debt and vice-versa.  Those who want to get started on the topic can consult: How to rebalance your investment portfolio. Now let us take on the questions.

Q1: When exactly we have to portfolio rebalancing? Is it based on goal time period or returns with risks? What’s the best way to do this? I’m sure consultation is necessary for this. A: Portfolio rebalancing first requires a target asset allocation. This needs to be set with the right return expectations; the risk profile of the need and risk appetite of the investor. This can be DIYed but yes, consultation with a SEBI registered fee-only investment advisor is certainly a good option.

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As regards, when to rebalance a portfolio, If the goals are several years away, once a year is good enough. With time anyway the equity allocation has to be decreased (well before the goal deadline not in the last three years!) and this would automatically take care of the rebalancing. This has to be planned in advance and a suitable amount invested.

Q2: If I have Nifty50 and nifty next50 as a part of my equity allocation, should I rebalance between them as well apart from the periodic equity and debt rebalancing? A: Not necessary. You can simply rebalance between equity and debt while reasonably maintaining N50: NN50 allocations. See: Should I rebalance between Nifty and Nifty Next 50 systematically?

Q3: 1. While you have recommended that yearly rebalancing is sufficient when to do more than 1 a year? What % of deviation (both sides) requires more immediate action. 2. If post rebalancing there is a crash what should be done?

A: Most investors make the mistake of assuming their portfolio allocation would be (should be) equity heavy for the most part of a long-term goal. As we have shown with extensive backtesting, the only way to guarantee we have enough money for our future needs regardless of market movement is by reducing equity well before our goal deadline. This means the equity allocation will gradually decrease. Each time the equity allocation is lowered, it becomes a natural rebalancing event.

Suppose you plan to decrease your target equity allocation by 20% after say seven years.  During this seven-year period, you can rebalance once a year. When you do that rebalance is a matter of personal choice.

Since rebalancing is both tactical (lower risk) and psychological (better sleep), an investor can check their asset allocation once a month. If they find that the allocation is more than 5% off from the target allocation, they can complete the rebalancing for that year immediately.

“If post rebalancing there is a crash what should be done?”. This depends on what rebalance was done earlier: From more of equity to debt or vice versa.  If you do not mind taxes and exit loads, you can rebalance once again! Or leave it be. There is no right or wrong way in personal portfolio management.

Q4: I did the rebalancing today, next my rebalancing is due 12 months away and target asset allocation is 60:40 for next 5 years. If there is sudden upward or downward movement of markets which results in allocation to 70:30 or 50:50 in next 3-4 months. Should I rebalance it immediately or do only as planned? Or should I set a threshold for the planned allocation, after which I should rebalance, say if there is 5% weightage change in target allocation?

A: You can either rebalance once a year no matter what or rebalance only when there is a 5% or more deviation. You can then change to yearly rebalance as your portfolio becomes heavier. However, before that, an equity reduction plan has to be put in place. That would take care of the rebalancing.

Multiple deviations above or below the threshold of 5% in the same year are quite unlikely. This is not something you should lose sleep on. If there two months in a year with amazing gains, you can remove some equity and safeguard it in debt. The reverse – two awful months can be ridden out or some money from fixed income shifted. The point is, there is no formula for personal portfolio management. No can tell you which choice is better. You will have to decide as it comes. Only a person with a clear plan will know how to improvise

Q5: 1. If the market swings like 30% in a few months, won’t I lose out if I do only annual rebalancing? 2. Am I missing out on anything if do 50:50 vs 70:30 as Equity: Debt ratio? 3. Why should individual goals be tracked separately as long as I have enough in my debt kitty? 4. I have US Equity exposure but it is considered as a debt fund from taxation purposes. Should I consider it as Equity or debt in my portfolio?

A: 1. The market will swing 30% only the day after you rebalance 🙂  If it swings down, you would feel great. If it swings up, not so much. There are only so many things in life we can control. There is no room for regret in equity investing.

2. Asset allocation target depend on return expectations, investments, risk appetite, risk required for the goal. There is no right or wrong allocation. Only suitable or unsuitable ones. 3. If you had enough in debt, there is no need for equity too 🙂 4. US equity is equity!!

Q6: When to rebalance if the target is > 10 years. A: every year with an equity reduction plan in place.

Q7: What if I don’t rebalance for the first 5 years or so, because my allocation is anyway low. Maybe start rebalancing annually post that 5-year milestone or a sizeable growth. A: In principle yes. If the annual returns in those five years were largely positive with a huge fall in the sixth, it would be classified as a missed opportunity!

Q8: How should an investor balance or choose when to continue goal-based strategic asset allocation and when to abandon it, and do tactical asset allocation (market timing), to make most of the special situations, like say Nov2016, Oct2018, Mar2020. A: Once can always mix strategies. I can rebalance in December each year but tactical enter or exit during the other months.

Q9: For most of us, salaried people who start investing late (relatively); a large allocation is in EPF/PPF; is there any harm to go full 100% equity for a few years, until we automatically bring E:D ratio to the red allocation; rather than starting off at 60:40. And avoid rebalancing until that time. Assuming the story has an emergency fund and doesn’t need to allocate debt for short term or has it separately.

  • In connection with this, in a long term like retirement goal tagged with debt-heavy portfolio epf/NPS, the equity part has no rebalancing, how can we handle the risk of holding equity portion alone(without any rebalancing) till the time we get to the desired allocation (using the reducing equity method)?

A: If the debt portion is heavy then there is no other option but to go all out on equity until the allocation reaches desired levels. However, it can be difficult to suddenly get used to such volatility. Naturally, there is no question of rebalancing here.

Suppose you currently have 80% debt and 20% equity for a goal that is 15 years away. Your portfolio changes to 70% debt and 30% equity because of a huge market gain. What would you do?

Do you remove 10% equity and shift it to safety (this is not rebalancing!) or do you leave it alone because your target asset allocation (eg. 50:50) has anyway not reached. That depends on what makes you sleep better. However, there is always a price to pay. If you keep doing this, you will have to compensate by investing more and more – which is even harder!

Q10: During equity portfolio rebalancing should one sell the profit-making stocks or it is better to get rid of the laggards. Also, if I want to rebalance by selling equity, where should one park the cash received? In liquid funds, PPF, or bank FDs.

A:  Use the rebalancing event to partially remove money from winners and partially declutter the portfolio. A portfolio (within an asset class or across asset classes) should always have winners and laggards at all times. If not it is not diversified properly 🙂

Q11: what should trigger portfolio rebalancing? The timeframe of rebalancing? A: A 5% more deviation from target asset allocation can trigger rebalancing. If you mean over how long one should do the shifting, in one shot.

Q12: How to do portfolio rebalancing? Is it done for NPS investment as well? What will be the approach for NPS then? A: Rebalancing refers to redeeming from one asset class that is doing well(!) and shifting the gains to another asset class.  Since you cannot redeem from NPS, you can use NPS as a long-term gilt mutual fund. See: Ten years of investing in the NPS: Performance report

Q13: Is N50, NN50 and liquid fund good enough for equity debt rebalancing? A: Asset allocation should always include all instruments tagged for a particular goal. If some instruments like NPS are inflexible, then yes, you will have to rebalance among the rest like the ones indicated.

The remaining questions are covered in the next parts: Portfolio Rebalancing FAQ Part 2 and Portfolio Rebalancing FAQ Part 3

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