December 15, 2011

Portfolio Re-balancing- How it works?

Today I will show you how to re-balance your portfolio regularly and what benefit you notice from this activity. Universal truth of investment is “Don’t put all your eggs in one basket”. Put it in different baskets so that if one basket fails to generate the required return then the other will compensate your investments. This is always true and you need to maintain this throughout your investment tenure.

However, how to decide how much percentage of your investment should be towards equity, debt or any other asset class? Common theory to judge is, consider 100 as your life span and deduct the current age from this, the remaining should be the % of your investment towards equity. For Example, suppose your age is 35 then deduct your age from 100 i.e. 100-35=65. Therefore, 65% of your portfolio should be towards Equity and 35% towards Debt. As you get older your equity exposure must decline and Debt portion need to increase in same proportion.

However, following above rule may cost you more sometimes. For example, suppose a person whose age is around 30 years and he have a plan to buy a car in the next 3 years. Then if we follow the above rule and invested major amount into equity may harm his short term goal. Hence, your investments also need to be based on the time frame. So second thumb rule to follow is-If goal is less than 5 years then always prefer Debt instruments (like Bank FDs, RDs or Debt Funds) else better to incorporate equity exposure.

Now how you can benefit from re-balancing of your portfolio?

Suppose Mr.Ajay is investing Rs.1,000 each in Equity Mutual Fund and Debt Mutual Fund for the tenure of 15 yrs. Approx Returns from Equity Mutual Fund 15% and Debt 9%. He is re-balancing his portfolio for each 5 years by maintaining 50% in each asset class.  Then

1) At the end of 5th year his Equity returns will be Rs.87,342 and Debt Rs.75,271. Which he will add and re-balance it to 50:50 in Equity and Debt. Also, continue to invest.

2) At the end of 10 year his Equity returns will be Rs.2,51,331 and Debt Rs.2,00,717. Again, he will add and re-balance it to 50:50 in Equity and Debt. Also, continue to invest.

3) At the end of 15 year his Equity returns will be Rs.5,41,957 and Debt Rs.4,23,037

Therefore, even though his total return without re-balancing is around 12.40% but this re-balancing will fetch you 12%. Hence, in this case you will not notice any such difference.

But you can’t predict always that Equity will give the same expected 15% return for the whole 15 years. Again we will consider Mr.Ajay who is investing Rs.1,000 each in Equity Mutual Fund and Debt Fund for 15 years. But we will not predict Equity returns this time while predicting Debt returns as 9%.

1) Suppose in the first 5 years the Equity gave the expected returns of 15% then at the end of 5th year his Equity returns will be Rs.87,342 and Debt Rs.75,271. Which he will add and re-balance it to 50:50 in Equity and Debt. Also, continue to invest.

2) But  in 6th to 10th year Equity market fell considerably and it gave only 8% returns then at the end of 10th year his Equity returns will be Rs.1,93,209 and Debt returns will be Rs.2,00,717 which he will add and re-balance it to 50:50 in Equity and Debt. Also, continue to invest.

3) From 11th to 15th year suppose Equity market again fell and it gave only 7% returns then at the end of 15th year his Equity returns will be Rs.3,47,849 and Debt Rs.3,78,323.

At end if you calculate his total returns then it will be work out around 8.79% which is more than average last 10 years return of Equity (8% 6-10 yr and 7% 11-15 yr, hence average will be (8+7)/2 is 7.50%)

Hence by re-balancing activity you preserved your money and got higher returns than what Equity gave during that turbulent last 10 yrs of Mr.Ajay’s investment.

However, is it possible to follow this re-balancing activity yourself? If you have time and bit of knowledge then you can do it yourself. Otherwise, it is better to take the help of any well-educated Financial Planners.

 

2 Comments

  1. Sir, I;ve one query. While maintaining portfolio, based on past expected returns, how can we say the returns will be same in future? In nut shell: how to plan expected returns in future

    Reply
    • Gourav-Apart from past data we don’t have any data which can make you assume the things for future. That is the reason portfolio rebalancing is to be done. If something went wrong in our expectation then we can correct that.

      Reply

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