What to keep in mind when rebalancing your portfolio?

IDFC AMC

Rebalancing a portfolio is a process of periodically adjusting portfolio allocation based on market movement. It involves selling and buying of different assets to maintain their original allocation.

If we consider a 50:50 allocation of equity and debt, and the market moves in either direction such that the allocation changes, the new allocation is again rebalanced into 50:50 allocation as below.

Rebalancing is mostly considered for lump sum investments and with a long tenure in mind. The initial asset allocation is decided and is maintained constant through all the fluctuations in the market. A static allocation implies asset allocation is decided at the time the amount is invested in each asset and is held without any changes.

We have taken Sensex and Crisil composite bond fund index as proxies for equity and debt, respectively. The percentage allocation can be of a different combination. Example 20:80, 30:70, 50:50 etc. in terms of equity and debt allocations.

If an investor has chosen 50:50 allocation to equity and debt, in case of fixed allocation, the portfolio will be rebalanced as per chosen frequency i.e. monthly, quarterly or yearly. In case of static allocation, the portfolio at the time of investment has been split in 50:50 allocation, which will run as is.

The below chart shows how a monthly rebalanced allocation and static allocation has moved over the last 10 years.

Consider Rs 2 lakh invested in 50 percent equity and 50 percent debt allocation at the start of each calendar year and held for 10 years.

If we compare both charts, the static allocation has higher volatility than the rebalanced allocation no matter which starting point.

The table displays the XIRR returns and the standard deviations for different time periods.

The standard deviation of the rebalanced portfolio is lesser than the static portfolio, indicating it is less risky.

An investor has a choice of various assets classes to choose from depending on his or her risk appetite.

For illustration, we have taken Sensex with various debt indices for the last 10 years for 50:50 allocation. The table shows how the different debt asset classes have faired for the last 10 years if rebalanced on a monthly basis.

We can observe that there isn’t much returns difference between static and dynamic allocation. However, volatility is reduced with rebalancing.

Various frequencies can also be adopted for rebalancing. Taking the example of the 50:50 allocation of equity (Sensex) and debt (CCBI), where yearly, quarterly and monthly rebalancing is done, quarterly and yearly rebalancing have done marginally better.

Observations from the analysis show that static and rebalanced allocation don’t make a conspicuous change in the returns earned but impact risk.

One should be aware of the costs involved in the rebalancing process. Also, the fact that the frequency also doesn’t make a large difference in the returns.

The process of asset allocation has to be followed, monitored and maintained. This reduces risks if an investor rebalances the portfolio. On the other hand, a balanced fund would automatically do this at a cheaper cost for the investor.