If you want to discuss about your financial needs or investments, we would welcome the opportunity to have a conversation with you.
Rebalancing is about changing the proportion of the various asset classes (debt, equity, etc) in your portfolio to better reflect your risk level and the current market conditions.
A portfolio’s debt:equity split is decided based on the investor’s risk profile. Over time this asset allocation might change because of market movements. For instance, you invest Rs.1,00,000- split 60% into equity and 40% into debt. If, over the course of the next year, equity markets have a good run and are up by 12%. Over the same period, debt markets give only a 4% return. Your portfolio weights would have moved away from their target allocation to 62.2% equities and 37.7% debt.
The resulting increased weight of equities means that the portfolio is, now, more risky. Why? Because stocks have historically had larger price swings than bonds or cash. This means that when a portfolio skews towards stocks, the portfolio has the potential for bigger ups and downs. And if your portfolio is skewed towards debt- it has lesser risk but that also means lower expected returns.
We have gone back 20 years and built a 60:40 portfolio with equity and debt. We have looked at the impact of yearly rebalancing on this portfolio.
| Rebalanced once every year | Never rebalanced | |
|---|---|---|
| Return (p.a.) | 11.66% | 10.72% |
| Risk (Standard Deviation) | 4.48% | 4.55% |
As you can see, the risk of the buy-and-hold portfolio was higher than that of the rebalanced portfolio. Not just that- the annual return of the rebalanced portfolio was higher by 0.94% p.a. over the 20 year period if the portfolio was rebalanced every year. This higher return would have generated 18.56% more money over the 20 year period.
This outperformance happened because when you rebalance, you tend to sell assets that have outperformed in the last season and buy the asset class which is underweight. So, you end up buying whatever is priced lower and selling what is priced higher.
Investing is an ongoing process. You need to create a plan, choose appropriate investments and track it to ensure that your portfolio stays on track. Rebalancing can be done in various ways:
1. Based on the drift:
Monitor your asset allocation and rebalance your portfolio only when the drift is significant. As a guideline, you may want to consider rebalancing only if the debt:equity split has moved by more about 3-5%. That is if a 60:40 become 65:35.
2. Based on time:
You can rebalance your portfolio every year or every two years. This way, you don’t have to worry about constantly monitoring your portfolio’s every small movement.
3. Whenever there is a transaction:
When you are adding money to your existing portfolio, you can do so in asset classes that currently fall below your target allocation. This way, you can avoid any tax implications that are involved in selling overweight assets.
4. Based on market movements and personal changes:
When markets change and new opportunities arise, portfolio’s target allocation might need to be thought through again. Also, if your personal circumstances change, that will change your target allocation. This means that your portfolio will have to be rebalanced accordingly.
Rebalancing is as important to your financial wellness as your initial investment decisions when you first set up your portfolio. It’s a continuous process that shouldn’t be overlooked.
All Millennium portfolios have allocation targets that are consistent with your risk level. Portfolios are actively monitored and rebalanced only after taking into account any tax consequences involved in the sale of overweight assets. Also, we try to rebalance your portfolios every time you make an additional investment or make a withdrawal.
If you want to discuss about your financial needs or investments, we would welcome the opportunity to have a conversation with you.