Before reading this article make sure you know about asset allocation. If you want to learn about asset allocation, read this article.
First let us, in a simple way, answer the question, what is portfolio rebalancing? Portfolio rebalancing is a risk managing/mitigating strategy. As time passes actual asset allocation deviates from the desired asset allocation. This happens due to different assets growing at different rates. At a fixed period or when the deviation crosses a certain level, rebalancing is done. Some units of the high-performing assets are sold and units of the low-performing asset of the same value are bought, with the aim of making the actual asset allocation the same as the desired value.
What is Portfolio Rebalancing?
We already have a brief definition of portfolio rebalancing, let’s look at it in a more detailed manner. Each goal in an investment plan will have predetermined asset allocation, based on acceptable risk and time period. But different assets will perform differently, thus some assets will grow faster than others. This results in a different asset allocation than the intended/planned asset allocation.
For example, let us assume we invested Rs 1000/- equally in equity and debt, i.e. 50:50 asset allocation. For first-year equity provided a 15% return and debt provided a 5% return. Thus after one year, our equity investment would have grown to Rs 575/- and Rs 525/- for debt investment. This translates to 52.3% in equity and 47.7% in debt in just one year. Over the years if similar performance continues the percentage of equity will become much more than the desired 50%.
To correct this deviation rebalancing of portfolio is done periodically or whenever required. To rebalance we sell the units of assets which has grown more and buy the units, of equal value, of assets that have grown less. In the example given in the last paragraph, we will sell equity of Rs 25/- and buy debt of Rs 25/-. Thus making the value of both equity and debt Rs 550/- and achieving the desired 50:50 asset allocation.
This is mainly done to keep the risk at the predetermined level. People in an attempt to emphasize the importance of portfolio rebalancing may mention some additional benefits of rebalancing. But it should be viewed only as a risk management strategy because that is the only guaranteed benefit of rebalancing.
Why do Portfolio Rebalancing?
First, let us be clear about one fact, no matter who you are, no matter what strategy you use, you cannot predict when the market will fall/rise and by how much. This applies to me too, as much as to any other person.
The biggest argument people give against rebalancing is that it is counterproductive to sell a high performing asset and buy a low performing asset. It is not wrong that rebalancing can reduce your returns sometimes but you cannot control the return you get in any case. What you can control is how much risk you are taking. If you do not rebalance, the percentage of the high performing asset, which most of the time has a higher risk too will keep increasing. Increasing the overall risk level of your portfolio.
In addition to this you can not know when the riskier asset will start a downward trend or how much will it fall. While you might be prepared to face this fall with your desired asset allocation if you do not rebalance the loss might become too much to handle.
If you are reading about portfolio rebalance and thus know about asset allocation, chances are you have some type of investment plan or are making one. You will or did invested efforts or money along with your time in this investment plan, of which asset allocation is an important part. The main aim of an investment plan is to provide structure to your investments and increase your chances of success. To forgo all of this just for a misguided and greed-driven thought of letting a high-risk asset grow way beyond your asset allocation limit for some uncertain return is utter foolishness.
So to summarise the main reasons for rebalancing your portfolio are:-
- No matter how prepared you are for losses, if you let the percentage of riskier assets grow uncontrollably all your preparation will be utterly useless.
- You never know when and how much an asset will fall. Thus a high percentage of a riskier asset will increase the impact of this fall.
- In absence of rebalancing your portfolio will become so deviated from your investment plan, that your plan will become just a waste of time, effort, and money.
How to do Portfolio Rebalancing?
While it might seem quite easy to answer this question but still some people may face some issues. So we shall have a look at, how to practically do portfolio rebalancing?
Let’s take an example of a portfolio of two different asset classes. At the time of rebalancing, you will require the following data:-
- The total value of the portfolio (TP)
- The current value of asset 1 (CV1)
- The current value of asset 2 (CV2)
- Desired asset allocation in percentage:-
Percentage of asset 1 (P1)
Percentage of asset 2 (P2)
Now calculate the value of each asset as per desired asset allocation.
- For asset 1 Desired Value (DV1) = (P1/100)*TP
- For asset 2 Desired Value (DV2) = (P2/100)*TP
If the current values of assets are equal to the desired values of assets, or very close, then no rebalancing is required. If there is a difference between the current value and the desired value, check which asset has a current value (CV) more than the desired value (DV). Let us assume that in our example asset 1 has a real value more than the desired value. So we sell units of asset 1 having a value equal to CA1 – DA1, i.e. difference in current value and desired value. And we buy units of asset 2 of the same value, thus making the current value and desired value the same for both assets.
This is what rebalancing is, calculating the desired value according to predetermined asset allocation. Comparing current value with the desired value, and making them equal for each asset by buying or selling some units. Thus achieving the predetermined asset allocation. While doing this some amount will be expended in exit loads, fees, etc and thus you might not achieve the exact asset allocation. This is fine as usually the amount will be quite low and the difference in asset allocation will also be very less.
When to do Portfolio Rebalancing?
The main problem with scheduling rebalancing is that if you do it too often the benefits are less than the effort and money lost in exit load, fees, etc. If you do it too seldom you expose yourself to higher than the planned risk in between. So answering the question of when to do rebalancing is very essential. There are three methods that you can use to determine the time of rebalancing.
- At the fixed time (Time Based).
- When asset allocation deviation crosses a certain level (Trigger Based).
- A combination of the above two.
Time-Based:- You can rebalance your portfolio at regular and fixed periods, like monthly, quarterly, semi-annually, annually, etc. You have to select a time period keeping in mind that it should not be too large or too small. Personally and according to many experts in the field of personal finance annual rebalancing is the most optimal option.
Trigger Based:- In this, you rebalance your portfolio when the deviation of asset allocation crosses a certain level. For example, if the asset allocation deviates by 5 points from the desired asset allocation you rebalance your portfolio back to the desired asset allocation. Here also the trigger should not lead to very frequent or very rare rebalancing. A trigger between 5 to 10 points in my view is optimal.
Mixed Approach:- This is the mixture of both above strategies. You can have a fixed periodic rebalancing, like annual rebalancing. In addition you can choose a high trigger like 10 points which will cause a rebalancing even before the annual (periodic) rebalancing. I implement this for my personal portfolio, annual rebalancing with a trigger of 10 points.
M. Pattabiraman sir has written a very good article analyzing different scenarios of rebalancing. You should definitely read it to have a more clear idea about when to rebalance a portfolio?
Until now I have been talking about balancing different assets as per desired asset allocation. But it is quite common to invest in more than one instrument within an asset. So should we rebalance the allocation of these instruments within each asset? This will also answer the question, which mutual fund I should buy/sell for rebalancing?
I have come across a few people who think that intra-asset rebalancing is going overboard, and it harms our returns more than it reduces risk. I do not believe this, like more than the planned allocation of an asset can increase the risk, so can over-concentration of any instrument in that asset. But I think this question should be answered in a more detailed manner rather than simply stating, yes do intra-asset rebalancing.
Let us look at asset class with low risk like debt and assets with high risk like equity separately.
In the case of debt assets, there are two issues. Mostly the debt asset portfolio comprises mutual funds, bank and post office deposits, and provident funds. Rebalancing the allocation of PPF, EPF, and VPF is mostly not possible as you cannot freely withdraw money from them. Also, provident funds along with bank and post office deposits have extremely low risk so we can accept a higher percentage of these in the debt portfolio.
Story changes when it comes to debt mutual funds, the risk profile of different types of debt mutual funds vary quite a lot. Thus rebalancing requirement will depend on which mutual fund/s a person has in his/her portfolio. If you only have a liquid fund there is no requirement for intra-asset rebalancing. But if you have a combination of more than one fund, like liquid fund plus gilt fund, you should try and keep their allocation as close to your plan as possible. How to do this will be discussed later in this section.
In the case of high-risk assets the number of products with lock-in is quite low (I am not considering investment+insurance products like ULIP for obvious reason), so rebalancing can be done easily. These asset classes have the largest effect on the overall risk of the portfolio, thus maintaining the risk in these to a comfortable level is very necessary. Thus intra-asset rebalancing is also necessary.
How to do Intra-Asset Rebalancing?
Let us take an example of a portfolio in which equity has grown substantially more than debt, thus you have to sell equity and buy debt. Calculate the amount of equity to be sold, now withing equity sell that instrument (stock or mutual fund) which has grown more than its determined allocation. Same way in the debt asset class, buy that instrument whose allocation has decreased in comparison to the desired value.
In this way, you will achieve almost exact asset allocation and within each asset class, the allocation will be very close to the desired value. This is fine and will suffice our requirements.
For more clarity let’s have a look at an example. A portfolio has 50:50 asset allocation for equity and debt. In each asset class, there are two mutual funds with a 60:40 allocation. We invested Rs 1000/- in each asset at the beginning of the year.
Fund 1 has Rs 600/- at the beginning, and we assume it gave an 8% return.
Fund 2 has Rs 400/- at the beginning, and we assume it gave a 15% return.
Fund 1 has Rs 600/- at the beginning, and we assume it gave a 4% return.
Fund 2 has Rs 400/- at the beginning, and we assume it gave a 6% return.
So at the end of the year the equity has following values
Total Value of Equity = 1108
Value of Fund 1 = 648
Value of Fund 2 = 460
And the debt has following values
Total Value of debt = 1048
Value of Fund 1 = 624
Value of Fund 2 = 424
To rebalance we sell units of Fund 1 in equity asset class having a value of Rs 30/- and buy units of Fund 1 of debt asset class of the same value. Thus making equity and debt allocation equal to 50:50 and within each asset the allocation of funds 60:40.
Systematically Reducing Equity Exposure
I was going to write this section in the asset allocation article, but it seems better to write it after explaining asset allocation and rebalancing. This way I have to explain less, and you will understand easily. I learned this concept from M. Pattabiraman, he has a wonderful goal-based portfolio management course, I joined this course when it was launched. I highly recommend it, you can find out more here.
So now back to our topic, most people who have a proper plan have an asset allocation that remains constant throughout. As they reach close to their goal they bring the equity to zero to make sure they don’t face any fall in equity so close to their goal. This is a good strategy, but there are some issues. How do you define close to the goal, is it 5 years prior or 3 years? You bring equity to zero too soon and you get low returns and will struggle to reach your goal. You do it too late you are facing a huge risk so close to your goal.
To tackle this and to reduce the risk even further you can systematically reduce the equity throughout the goal. This means reducing the allocation of equity periodically, such that becomes zero at the end. You can reduce equity annually, after every 2 years, after every 3 years, etc based on your needs. This will increase the amount you need to invest for that goal, but the benefits of this strategy far outweigh this.
For example assume you have a goal for which you have 60:40 equity debt asset allocation. The time period for this goal is 10 years. You can reduce equity every year such that it becomes zero for last year. Your equity allocation for each year will be.
A diversified portfolio with proper asset allocation and timely portfolio rebalancing can lead to a successful financial life.