Understanding Volatility of Investment Returns with a Portfolio Rebalancing Simulator

Published: July 18, 2013 at 7:00 am

Last Updated on October 4, 2016

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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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, IIST Alumni Association. For speaking engagements write to pattu [at] freefincal [dot] com
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