The What, Why, How and When of Portfolio Rebalancing With Calculators to Boot

Published: May 23, 2013 at 6:00 am

Last Updated on

Beginning to invest for a long term goal in accordance with a plan is an important first step. Once the investing process is underway,

  • performance of the instruments chosen have to be monitored
  • the portfolio rebalanced
  • the goal plan re-evaluated annually and
  • a few years away from the goal-date a plan to shift funds from risky instruments to risk-free instruments should be in place.

Among these steps portfolio rebalancing is a concept not well understood by many. Let us first try to answer, why a long term investment portfolio should be monitored? This will naturally lead us to the idea of rebalancing. We will then look at the types of rebalancing and which among them is optimal.

Portfolios associated with long-term goals will/should have substantial equity component. Equity is a proven way of beating inflation over a long time. However investors must accept two aspects of equity investing:

  • Returns are volatile. You can get a return of +25% one year and -45% the next. If you stay invested for a long enough period the average return is likely to be above inflation. However volatility of returns can influence your final corpus amount. If you are investing for retirement, volatility can reduce the life of your retirement corpus (how long your money will last) by a good 2-3 years.
  • Sequence of returns. When, you enter the market can make a significant difference to the corpus you accumulate and how long your money will last when you are retired. A series of poor returns early in the investment tenure requires strong discipline to stay invested. A poor run towards the end of the investment tenure requires an immediate shift from equity to debt to minimize losses.

Therefore long term portfolios require constant monitoring. When you are accumulating a corpus, sequence of equity returns can be handled with disciple and prudence. Minimizing volatility of returns requires a little bit of know-how in addition to discipline.

Powers of compounding illustrations never mention anything about volatility! Presence of volatility implies that when returns exceed expectation some portion of it must be shifted to less volatile debt instruments. This safeguards the fruit of compounding since what goes up will come down. On the other hand what goes down will go up. So when returns turn negative we need the disciple to shift funds from debt instruments into equity. This enhances returns when they turn positive. Such periodic shifting of funds from equity to debt and vice versa is known as rebalancing. It is a process by which volatility is contained. If you had got a return of +25% in one year and immediately shifted some portion of your equity portfolio to debt then your loss would be lower if the next year return was -45%. Of course the gain would also be lower if it was +45% instead! That is a chance you will have to take. Rebalancing is a methodical way of ‘buying low and selling high’. Many define rebalancing as a way of realigning your portfolio to match your risk appetite. This is just one way of rebalancing. The correct and simplest definition: rebalancing refers to any means used to contain volatility in a portfolio.

How does one rebalance? What portion of funds do we shift? How often do we do it? There are many ways of rebalancing a portfolio. It is not tough to think of new ways once you get the hang of it. Here are a few popular ways:

Periodic Rebalancing: Let us say you start SIPs with 50% of what you can invest in equity and 50% in debt. A year later you inspect your portfolio. If it reads 45% equity and 55% debt you shift 5% from debt to equity. If it reads 60% equity and 40% debt you shift 10% from equity to debt. That is you shift funds such that the portfolio reads 50% equity and 50% debt at the start of each investment year. A detailed example of this can be found in the calculators.

  • Your equity and debt SIP amounts remain the same and are not part of this rebalancing exercise.
  • Initial asset allocation (example of 50:50 considered above) should match the goal profile (time frame and importance) and the risk appetite of the investor.
  • The above approach can be varied in many ways. You start with (equity)50:50 and instead of rebalancing to 50:50 each year you rebalance to say, 60:40 or to 45:55.
  • It is usual to do this annually. However it can be also done at any interval of choice. Every 6 months, every 2 years etc.

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, say 3% or 4% or 5%. That is, after year one if the portfolio reads 52:48 you do nothing. It reads 45:55 you do nothing. If it reads 56:44 or 40:60 you rebalance back to 50:50.

  • Here too the interval is variable. For example you rebalance only if the equity component changes each year by the threshold you set (3-5%). You can also do this every 6 months or even monthly.
  • The rebalancing can be also be made a one-way process. That is if equity gains by, say 5% you shift this excess to debt. If equity loses by 5% you do nothing.

Which is the best way to rebalance?

  •  The calculators will help you decide that! Using historical Sensex and FD returns this is what I found:
  • Annual rebalancing is pretty efficient. For all possible 15 years periods between 1980 and 2011 the rebalanced portfolio was larger than the un-rebalanced one by an average 13%! This is for a 50:50 initial asset allocation. The difference will be higher if the equity portion is more.
  • Annual rebalancing is (typically) much more efficient than bi-annual or tri-annual rebalancing.
  • Annual rebalancing can make a retirement corpus last about 2-3 years longer.
  • Rebalancing makes a bigger difference in case of lump sum investments when compared to SIPs
  • Threshold rebalancing is also pretty impressive. For all thresholds bet. 1-5% and for the parameters as above (15 years and 50:50) the average was the same 13%. For other situations the threshold rebalancing outperformed annual rebalancing. You can use the calculators to find out.
  • Tax and exit loads are important factors while considering annual rebalancing. Threshold rebalancing is better since rebalancing occurs typically occurs once in 2-4 years depending on the threshold.
  • The threshold should be small. Anything more than 5% will decrease equity a little too much and affect compounding.
  • One-way rebalancing is a waste of time as it kills compounding.

Bottomline: Rebalancing should minimise volatility by safeguarding the fruits of compounding. Trouble is overdoing it will ruin compounding. So you need to strike a balance.

I would prefer threshold rebalancing with a threshold of about 4-5%.  Don’t take my word. Try out these rebalancing simulators and make your choice.

Rebalacing Simulator Lite: Suitable for investors unfamiliar with rebalancing. It contains,

  1. Rebalancing illustration
  2. Annual rebalancing simulator with lump sum investment
  3. Annual rebalancing simulator with SIP investment
  4. Annual rebalancing simulator & Lifetime of retirement corpus
  5. Sample data

Sheets 2 and 3 have ‘macros’ to determine the average rebalancing benefit for all possible durations between 1980 and 2011.

Comprehensive Rebalancing Simulator: Suitable for finance pros and pro-investors and anyone willing to learn. It contains,

  1. Rebalancing illustration
  2. Annual rebalancing simulator with lump sum investment
  3. Annual rebalancing simulator with SIP investment
  4. Variable Frequency rebalancing simulator (1,2,3… years)
  5. Threshold rebalancing simulator
  6. One-way rebalancing simulators
  7. Annual rebalancing simulator & Lifetime of retirement corpus
  8. Sample data

Sheets 2-7 have ‘macros’ to determine the average rebalancing benefit for all possible durations between 1980 and 2011.

Download the Rebalancing Simulator Lite (enable macros)

Download the Comprehensive Rebalancing Simulator (enable macros)

Q: Which do you think is the best rebalancing mode for growth-SIPs? (SIP amount increases by some % each year).

This is part II of the Step-By-Step Guide to Long Term Goal-Based Investing. Part I can found here.

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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