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Portfolio rebalancing during goal-based investing: why, when and how?

Rebalancing is a simple way to buy low and sell high while managing risk. Here’s how you do it.

Portfolio rebalancing during goal-based investing: why, when and how?

Posted on 10 May 2021
Author: Sayan Sircar
10 mins read
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Rebalancing is a simple way to buy low and sell high while managing risk. Here’s how you do it.

Portfolio rebalancing during goal-based investing: why, when and how?

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Rebalancing is a vital risk management tool to achieve one objective: portfolio risk over time needs to be managed per market movement and horizon of the goal. For example, bull markets make the portfolio’s equity component go up, increasing the portfolio’s risk once a market correction comes. Having the plan to rebalance from equity to debt manages this risk. Similarly, there is a buying opportunity in a bear market if you sell a part of debt holdings to buy equity. Also, as the goal comes closer, the portfolio’s risk must be lowered by lowering the equity component. Rebalancing allows this as well.

Rebalancing allows you to

  • Systematically buy low and sell high
  • Should be done at the portfolio level (all goals together to minimize the number of trades and taxes)

Here is a detailed post on how to get your risk profile for any goal in case you want to review that first.

In general, rebalancing is a trade-off where you balance the effects of mean reversion (what goes up will eventually come down and vice versa) and momentum (what goes up/down will keep going up/down for some time). Thus, there is no need to time market top/bottom while rebalancing as long as a systematic process is followed.

Why rebalance?

Rebalancing removes key behavioural issues that affect investors:

  • timing the market: rebalancing rules are systematic, which removes the need for manual decisions regarding when to enter and exit
  • remove emotions: investors tend to hold on to both winners (greed) and losers (fear of loss) for too long. Rebalancing can solve this problem, assuming what has gone down is something that should continue to be a part of the portfolio

For example, a starting portfolio with a 60:40 equity-to-debt ratio can become over time 70:30 due to market movement, i.e. equity going up faster than debt. However, your target asset allocation, which as per your risk profile, should be 60:40, has now changed. So you sell a part of your equity to buy into debt (one sell transaction followed by immediate buy once you have the money) to bring the balance back to 60:40. This allowed you to “book profits”, and you could sell high (since equity has gone up) and buy low (since the debt portion has not gone up that much.

This works in reverse as well. Equity markets generally fall 10-15% annually, and opportunities keep arising (see image below). This is where you can profitably use corridor rebalancing.

Nifty Yearly movement

We have covered this particular topic in more detail in this post: Is there a correction in the stock markets?

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Rebalancing reduces uncertainty in the portfolio

Case 1: 100% equity and no debt

Case 1 with 100% equity and no debt

Here is an example of a 15,000/month SIP run for 15 years. The SIP amount is increased by 5% every year. The chart shows ten different possibilities assuming the average equity return is 11% post-tax and risk of 15%. The results are:

  • maximum value: ₹ 166 lakhs
  • minimum value: ₹ 44 lakhs

Here is our article about the danger of having only equity without rebalancing: The lie of wealth-creation via SIP in mutual funds

Case 2: 60:40 fixed asset allocation and then rebalanced

Case 2 60:40 fixed asset allocation and then rebalanced

The variation in the previous case is the effect of market risk that shows us that the returns of the equity market are unpredictable. Since we need market risk to make high returns, we need a way to manage this risk. Rebalancing via a suitable asset allocation is the solution here which will be via allocating to equity and debt. For this example, we will invest 60% in equity and 40% in debt and keep this allocation fixed for 15 years by rebalancing annually. We will use the same sequence of equity returns as before. As these results show (corpus range of ₹49-108 lakhs), the variability is now lower.

This is still not ideal.

Portfolio allocation models for Indian investors

Case 3: Reducing equity asset allocation, rebalancing done annually

Here we extend the concept of asset allocation and introduce the idea of the glide-path that will allow us to manage market risk. We start at 60% equity (the rest will be in debt) and gradually reduce that yearly until it drops to zero when you fully invest the corpus in debt.

Case 3: Reducing equity asset allocation, rebalancing done annually

We see that the range is finally predictable, as the results show with the corpus range of ₹60-66 lakhs. This example also shows the effect of diversifying the asset allocation and managing risk via rebalancing.

This article shows the difference of the average, maximum and minimum returns of various asset allocation values: Should Indian investors invest 100% in equity for their goals?.

When to rebalance?

The new target weights of equity: debt for each goal will be per the portfolio glide path for that goal. Once you have the target weights, two general methods trigger rebalancing:

  • Calendar method: rebalance every 12 months, six months or quarterly - make a rule and stick to it - there is no good or lousy interval to pick
  • Corridor method or constant-mix strategy: rebalance whenever weights change by a fixed value say 5% (e.g. 60:40 will be rebalanced whenever 65:35 or 55:45 happens) - the 5% value is a thumb-rule that can be used as per the current portfolio weights of various assets

You can also combine the two methods: have yearly rebalancing but monitor the market for significant falls/rises and use the corridor method. As mentioned earlier, the equity component of the goal will generally reduce as the goal comes closer - this means a 60:40 equity: debt portfolio may need to become 40:60 a few years later via rebalancing.

An advanced technique called constant proportion portfolio insurance (CPPI) can be used by investors comfortable managing their portfolios for some time.

How this double-income family needs to perform rebalancing to reach their financial goals.

How does rebalancing impact compounding?

Compounding formula

If we look at the compounding formula, rebalancing does not impact any of the terms in the equation. Rebalancing does not remove money from a portfolio. Instead, it moves money from either one asset class to another (like selling equity and buying debt) or from one fund to another (e.g. selling large caps to buy mid-caps).

Rebalancing and taxes

Since rebalancing requires selling, there will be exit load and capital gains taxes. Still, these are minor considerations of the benefits that rebalancing brings. However, it would be best if you did not do this too often since taxes will become very high. As noted in our article on capital gains taxes, the short-term capital gains limit for non-equity mutual funds is three years. Since investors invest in SIP mode, each new installment will be taxed at the marginal tax rate (i.e. 30%) if sold within three years for rebalancing. Funds investing in international stocks, all debt funds and many fund-of-funds have this three-year taxation rule.

It is therefore essential to strike a balance. Investors who are unwilling to sell funds due to the tax impact, as a compromise, may want to consider pausing investments in funds/asset classes marked as a “sell” and instead invest in those marked as a “buy”. This method achieves a similar effect but reasonably slowly. However, this slow rebalancing also leads to incorrect risk exposure in the portfolio. The figure below explains how slow rebalancing becomes more and more ineffective with time:

When returns are higher than contributions

In the beginning, it may be possible to adjust monthly SIP amounts to rebalance. Still, this will not be possible once the portfolio becomes more significant relative to the monthly investment. In general, investors who have just started investing with small portfolios will not see many benefits due to rebalancing by selling assets. They should wait some time until their portfolio becomes big relative to their monthly investment. Investors implementing core-satellite portfolios will need to rebalance frequently to manage their risk.

Read more on slow rebalancing here: How compounding works: the journey to a 10 crore portfolio

How to rebalance?

Rebalancing means selling an asset that has gone up and using the sale proceeds to buy another asset that has not gone up. Rebalancing is also an opportunity to get rid of active funds which are consistently underperforming their benchmarks. These are steps that you can follow:

  • value all your assets (stocks, funds and everything else that is a part of the portfolio)
  • calculate asset allocation for all goals (target will depend on portfolio glide-path) and compare that with the current allocation
  • tag the assets to goals (you should already do this at the beginning of investing. Read this if unsure)
  • for each asset whose current weight is above the target should be sold. Please get rid of dud funds/stocks at this step irrespective of their current weight
  • for each asset that is below the target should be bought (using the cash from the previous step minus taxes that need to be paid)

Another way of rebalancing using triggers is explained in this article: How to use the bucket theory to plan for your goals?.

Some example calculations for convenience:

  • Current allocation equity: debt is 65:35, and corpus is ten lakhs (6.5L equity, 3.5L debt)
  • Target allocation is 60:40, i.e. 6.0L equity, 4.0L debt as per current risk profile and glide path.
  • Sell 0.5L equity and invest into debt so that equity = 6.5-0.5=6.0L, debt = 3.5+0.5 = 4.0L [there may be a tax impact that needs to be paid as advance tax or during ITR filing]

Caution: Many new investors have significant investments in debt via Provident fund (PPF/EPF) locked until maturity and generally do not allow easy withdrawals. For them, opportunistic rebalancing from debt to equity can be difficult until a significant liquid corpus in debt funds is accumulated. See How to choose a debt mutual fund for all goals. Investors investing in NPS Tier 1 also have limited control over the asset allocation being followed and do not have an opportunity to rebalance.

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