Why does portfolio rebalancing work

For many investors, creating a portfolio is an end in itself for attaining the financial goal. Once you have assessed your risk profile, decided your asset allocation and created a portfolio based on that, is your first step towards your financial planning. After this, you need to keep track of your investments and re-balance them whenever necessary.

Re-balancing in a simple word is bringing your portfolio back to the desired asset allocation. For example, if you start with a fund of Rs. 100 and have decided an asset allocation of 60:40; that is 60 per cent of your fund is invested in stocks while remaining 40 per cent is invested in debt. After one-year, better movement in the stocks has resulted in the appreciation of your stocks by 10 per cent while in the same period the value of your debt investment has declined by 15 per cent. Now after one year, weightage of your portfolio changes to 66:34, which is not your desired asset allocation. Therefore, to bring it back to the planned ratio, you will sell some part of your stock portfolio and invest in debt part. This is known as portfolio re-balancing.

According to various research, re-balancing helps you to improve your risk-reward ration. In ‘Rebalancing Diversified Portfolios of Various Risk Profiles’, author Cindy Sin-Yi Tsai looked at a number of rebalancing methods including never rebalancing, monthly rebalancing and quarterly rebalancing. The study clearly shows that portfolios that were never rebalanced had the lowest Sharpe ratios, which measures risk-adjusted return.

One of the reasons why re-balancing works is because every asset class tends to revert to the mean over time. This means that if in the last 20 years, the average return generated by equity is 15 per cent, it is not consistent, but some year like 2008, it dropped by 50 per cent the next year it increased by little more than that percentage and finally the average comes at 15 per cent.

By re-balancing, you tend to sell a portion of your winning asset class before its returns get back to mean. In the same time, you are even buying an underperforming asset that is likely to go up in the following years while catching up on the average returns. It’s not necessary that next year outperforming asset will underperform while underperforming asset will outperform next year, the rebalancing will help you to control your risk.

Tune in to this space to know how to rebalance your portfolio.