Key takeaways
- Re-balancing can increase returns by approx. 0.5% (i.e. approx. 14% over 30 years)
- Re-balancing helps automatically reduce the risk level in your portfolio during bull markets or bubbles
- Re-balancing helps you build a very important habit that is crucial for investment success i.e. the psychological conditioning to be able to buy low & sell high.
- Valueresearch data shows that re-balancing your portfolio when it deviates by between 10 to 15% seems optimal
- Dr. Bernstein believes that re-balancing once every 2 to 5 years is optimal
This article would be useful for an investor who would like to reap the benefits of re-balancing in terms of returns, risk reduction & building a powerful habit needed for investment success. It also looks at addressing the one key difficulty in re-balancing which is to figure out when & therefore how often to trigger re-balancing. It would also be useful for someone who understands the benefits but has been struggling to implement it in practice
This article is for people who are retired or for any other reason are not doing an SIP and have therefore reached their target equity allocation.
My earlier article was for those who are doing an SIP. It explained a strategy that is something like a combination of something like an SIP with automatic re-balancing. This helps generate significantly higher returns than an SIP in a bear market.
Benefits of re-balancing one’s portfolio
In general, re-balancing one’s portfolio has the following 3 benefits:
1. Returns enhancement
As a recent example, here’s some data from below valueresearch showing how rebalancing has helped since the time the 2024 bear market began in India.
Look at the green line on the chart to the right which shows the re-balanced portfolio. It’s clear that in the recent bear market over the past year & a half at least that the re-balanced portfolio has stayed ahead of the one that hasn’t been re-balanced.
As per Dr. William Bernstein, re-balancing your static (non-SIP) portfolio can help generate approx. 0.5% extra returns in the long term.
While 0.5% may not sound like much, one shouldn’t underestimate the long-term impact of a 0.5% enhancement in returns. Let’s illustrate with an example. If you have a portfolio of Rs. 1 crore at the start of retirement and if you earned 10% returns for 30 years, then at the end of retirement you would have approx. 15.86 crores. On the other hand, if you earned 10.5% with re-balancing, you would have 18.09 crores. That’s a difference of approx. 2.23 crores just by implementing a simple re-balancing exercise. i.e. a 14% difference in net worth at the end of 30 years.
2. Risk reduction
During a bull market or a bubble, re-balancing forces you to reduce your equity exposure or your exposure to any asset class that has run up a lot, thereby reducing your risk. See the 3rd column in the table below. It clearly shows how risk increases as one increases one’s equity allocation.
3. Powerful habit for Investment success that’s difficult psychologically
Fundamentally, in order to succeed at investing, you need to learn to buy low & sell high. Instilling the re-balancing habit ensures you build what’s psychologically & emotionally needed to develop the above trait because that’s exactly what re-balancing requires you to do – buy low & sell high.
That seems easy in theory but both are difficult to do in practice.
Buying low is difficult in practice because it normally needs to be done in an environment where:
a) an asset has been falling in value recently e.g. Indian equity markets currently as compared to say US equity
b) has been giving low returns in the recent past and e.g. Indian equity markets currently as compared to say US equity
c) there is a lot of negative news about that asset class.
Selling high is difficult in practice because it normally needs to be done in an environment where:
a) The asset has been rising in recent times e.g. when gold was rising recently how many were able to sell gold?
b) The asset class has had high returns in recent years – e.g. US equity in recent years as compared to India
c) There is euphoria in the media about the asset class
What is re-balancing: An example
Re-balancing only works when you have a previously determined asset allocation i.e. what percentage to invest in equity vs debt.
During a downturn you just need to add sufficient money to your equity assets to get back to your originally decided equity level. Conversely, during a bull market or bubble, you sell enough of the asset that has run beyond target allocation to bring it back to it’s target.
As an example, let’s say someone has 1 crore invested between equity & debt and they had decided on a 60% equity & 40% debt portfolio allocation. This means that before a market downturn their equity portion would have been 60 lakhs (40 lakhs in debt) Now if due to the market correction their equity portion is down by say 10%, their equity portion would be down to approx. 54 lakhs. Most likely, the debt portion would have stayed at 40 lakhs. So now the new total value of the portfolio is 94 lakhs. We need this 94 lakhs to be split 60:40 between equity & debt. So the equity portion needs to go up to 60% of 94 lakhs i.e. 56.4 lakhs. So we sell 2.4 lakhs from the debt portion and invest the same amount into the equity portion of our portfolio.
As you can see above, re-balancing helps give you a formula by which an investor can know exactly HOW MUCH more to buywhen prices are low or depressed thereby increasing an investor’s returns in the long run.
WHEN to re-balance your portfolio
When a market is falling over a period of days, weeks, months or years, it can be difficult to decide WHEN to trigger the re-balancing exercise. For example, as markets keep falling, an investor is left with a range of options of whether to re-balance when markets fall by 1% or by 20% or something in between OR indeed whether to re-balance daily, weekly, monthly or yearly in a falling market.
The key to re-balancing therefore is to create your own guideline or rule that help you decide WHEN to trigger the re-balancing
Asset allocation % deviation-based triggers
One option is to setup a rule for yourself that says for example “If my allocation of any asset class is over or under my target allocation by more than 10% I will re-balance.”
To help you decide, here is some analysis from Valueresearch that shows how various percentage deviation level re-balancing triggers have worked in the past based on Indian equity market history.
As you can see from the green shaded cells of the tables above, the data shows that re-balancing your portfolio when falls by between 10 to 15% seems to produce the ideal result.
Time based re-balancing
Above we’ve covered threshold based re-balancing triggers. However, another equally valid & powerful approach is to trigger re-balancing at periodic intervals of time.
In his book, The Four Pillars of Investing, Dr. William Bernstein says that the answer based purely on Historical data analysis seems to suggest that re-balancing once every 2 to 5 years.
Another interesting point he makes is that research has shown that the tendency of prior best performers to do worse and vice versa seems to be strongest over about 2 to 3 years. On the other hand, for periods of one year or less, the reverse seems to be true. i.e. the best performers tend to persist, as do the worst.
So clearly, re-balancing more than once a year is probably not a good idea.
You could also consider creating some kind of hybrid threshold & time based rebalancing trigger rule for yourself that goes something like: “I will rebalance if my target allocation deviates by more than 15% OR once every 3 years”
Summary
In summary, re-balancing can help enhance returns by approx.. 0.5% (which amounts to about 14% over 30 years), helps reduce the risk level of your portfolio during bull markets and helps you build a very important habit that is crucial for investment success i.e. buy low & sell high.
One should create a rule / guideline for oneself as to when to trigger rebalancing. That rule can be based on how much your allocation deviates from it’s target or time based or a hybrid one that combines time based & threshold based triggers if that sounds better.
Disclaimer: I am not a financial advisor. My articles are meant for people who are not savvy or well versed with personal finance and investing and find it difficult to grasp all the jargon typically used when discussing such topics. I hope to be able to demystify investing and make it as simple as possible for everyone. I’ve invested in Mutual funds for approx. 24 years. I’ve also been a diligent student of the subject of investing over the past 24 years learning & applying the writings of luminaries in the field. In these articles I’m merely sharing my experience & learning from that investing journey and the books of luminaries in the field in the hope that it might help others in some way. I am in no way directly or indirectly claiming to be a hot shot investor who has generated exceptional or even above average returns during my investment journey. However, I am quite confident that even if all you do is learn from my mistakes, educate yourself on sound investment principles & develop good financial habits you will benefit greatly. Please ensure that you consult a financial advisor before taking any decisions or actions concerning your personal finances or investments. I shall not be liable.
Credits: Dr William