Understanding Volatility of Investment Returns with a Portfolio Rebalancing Simulator

A long term investor should:

  • recognise all the risks associated with the financial goal
  • estimate the monthly investment needed (estimate not determine)
  • understand the need for spreading the investment risk (asset allocation)
  • understand the need for diversification within an asset class,
  • choose investment vehicles wisely
  • initiate investments as quickly as possible without worrying about perfection
  • maintain disciple, stay invested and stay the course
  • monitor the performance of investments periodically
  • rebalance the portfolio to ensure the volatility of returns do not spoil the fruits of compounding.

In the post on Understanding the nature of stock market returns, I considered a way to make sense of fluctuating (or volatile) investment returns and how volatility and risk are two different aspects of investing.

In this post I present the third version of my rebalancing simulator which can be used to understand how fluctuating returns can still ‘add up’ to a decent effective return and how periodic rebalancing of the portfolio can help reduce volatility and enhance returns.

If you would like to know more rebalancing and how to rebalance a portfolio with SIPs, read this:

The What, Why, How and When of Portfolio Rebalancing With Calculators to Boot (part II of a four-part series on goal based investing)

scalesThis describes different ways of rebalancing a portfolio and has two types of rebalancing simulators: a ‘lite’ version for the investor and a ‘pro’ version for enthusiasts and finance pros. These represent the second version of the rebalancing simulator. Version-I had minor bugs and is no longer available.

The third version gives the effective annual portfolio return with- and without rebalancing. You can use this calculator to

  • get a feel for volatility associated with equity using historical Sensex returns
  • understand how, when the volatility is averaged (geometric mean or CAGR) over a long period it produces a healthy, inflation beating return.
  • understand the effect of rebalancing year after year
  • recognise that although rebalancing can reduce the portfolio returns for a few years, it still produces a better return than a portfolio with no rebalancing
  • realise that the key benefit of rebalancing is to reduce the influence of negative returns. Periodic rebalancing can reduce the influence of positive returns as well. This is a price to pay for preserving the effect of compounding
  • understand that when goal planning or retirement calculators ask you for the ‘average’ portfolio return they refer to the final effective return (CAGR) and not the actual rate at which you portfolio will increase

Coding Challenge:  The calculator uses Excels XIRR function for each and any investment year chosen irrespective of the investment duration. Implementing this in Excel was quite challenging – perhaps just a notch lower than making the Daily vs. Monthly SIP calculator.

Download the Portfolio Rebalancing Simulator – Version 3 (macro enabled)

The calculator is reasonably straightforward and simple to use. If you need any assistance let me know.

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10 thoughts on “Understanding Volatility of Investment Returns with a Portfolio Rebalancing Simulator

  1. Sir,
    These are really useful. Would you at some point consolidate all these related posts on goal based planning and then portfolio monitoring and rebalancing into an interactive e-book or an app ? Would be willing to buy it !

  2. Hello Sir,

    Have you by any chance created a xls to calculate VIP investment. In one of your posts I read that Don’t reduce the SIP amount but pump the money in equity when market goes down. For this I need to know that market is actually down. One more thing is, if the NAV value of a MF is in almost the same for a period of say 4-5 months then actually it is like down market only and I can put more money. But How much I should put extra is the question.
    Please let me know if I couldn’t communicate the question properly

    1. Hi Veeresh,
      Check these our for VIP vs SIP plus more.
      http://freefincal.com/comprehensive-mutual-fund-investment-mode-comparator/
      http://freefincal.com/comparing-sip-vip-investment-strategies-with-sensex-monthly-returns/
      http://freefincal.com/revisiting-the-sip-vs-vip-debate-with-fundsindias-report-on-vip-investing/

      How much extra to put simply depends on how much you can!
      This is what I do.
      I don’t do a SIP anymore. Each month after I receive my salary, I look monitor the market (sensex/nify, bse 500 anyone). when the market dips by 1-2% in the first 10 days or so, I buy that day. If the market does not fall in 10 days, I invest anyway.

      I don’t need to start or stop SIPs this way. Another way of doing this is to follow this:
      http://www.stableinvestor.com/2013/05/how-to-use-recurring-deposits-to-make-money-in-stocks.html

      1. Hi Pattu,
        How do you check that market has dipped by 1-2%. I mean what refference do you take. Could you please tell me the procedure.

        Regards,
        Veeresh

        1. Nothing terribly smart. Just monitor an index. Typically most folios have more large caps in them. So nifty or sensex should do. Each month after I receive my salary, I monitor the Sensex for the first few days. The day when there is a huge dip by around 2 pm, I invest. Of course it may so happen that from 2 to 3:30 pm the market will rally. If the initial dip is huge, this is unlikely.

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