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What is Portfolio Rebalancing? How it helps?


You start with a certain asset allocation mix.

At regular intervals, you bring your portfolio to original asset allocation mix.

Let’s say you have Rs 20 lacs to invest. You have two asset classes Equity and Debt.

You invest Rs 10 lacs in Equity and Rs 10 lacs in Debt. Asset allocation of 50:50.

During the next 1 year, Equity gives 20% returns while Debt gives 5% returns.

Your investment in Equity grows to Rs 12 lacs. Investment in Debt grows to 10.5 lacs. Total portfolio is 22.5 lacs.

After you rebalance, you will have equal amounts in equity and debt i.e. Rs 11.25 lacs each.

To achieve this, you will have to sell some portion of Equity and use the proceeds to purchase some debt.

You repeat the exercise every year. And that’s what rebalancing is all about.

How Rebalancing helps?

Rebalancing can help reduce volatility in your portfolio. In some cases, it can lead to higher returns too.

Let’s understand this with the help of an example.

You invest Rs 10 lac on January 1, 1989. You invest half the amount in a Sensex index fund and the other half in a fixed deposit that gives you a guaranteed 8% p.a.

Assumptions: 8% p.a. for 30 years on a fixed deposits for 30 years sounds unreal but play along. For the sake of simplicity, let’s ignore taxes. Let’s further assume that the index fund perfectly replicates performance of the index. I have considered the Price index (and not the total returns index) for calculations in this post.

Scenario 1 (You leave the corpus untouched)

Rs 5 lacs invested in the Senex index fund on January 1, 1989 grows to Rs. 2.7 crores as on December 31, 2018. That is a CAGR of 14.2% p.a. over 30 years.

Rs 5 lacs invested in the fixed deposit grows to Rs 50. 31 lacs as on December 31, 2018.

Adding the two numbers, you have a sum of Rs 3.21 crores. CAGR of 12.26% p.a.

Maximum return for the year: 63.25% (2009)

Worst return for the year:  -44.94% (2008)

No. of years with negative returns: 7

Annual loss more than 15%: 1

Std. deviation of annual returns: 23.84% (Std. deviation is a measure of volatility).

At the end of 30 years, your portfolio is 84.3% equity and only 15.6% debt. This is because equity have given much higher returns over the last 30 years.

Scenario 2 (You rebalance at the end of every year)

Rather than letting the portfolios grow, you rebalance your portfolio at the end of each year i.e. you make adjustments so that the asset allocation goes back to 50:50.

If equity has done better during a particular year, you sell some equity and purchase debt.

If equity has performed badly (worse than fixed deposits), you take out some money from the fixed deposit and put that in the index fund.

With this approach, at the end of 30 years, you end up with 3.22 crores, slightly higher than the untouched corpus. CAGR of 12.27%. Clearly, not too big a difference to bother about.

However, you must also think about how you got there.

Maximum return for the year: 45.05% (2009)

Worst return for the year:  -22.22% (2008)

No. of years with negative returns: 6

Annual loss more than 15%: 2

Std. deviation of annual returns: 16.17% (Std. deviation is a measure of volatility).

 what is portfolio rebalancing benefits nifty returns financial planner
portfolio rebalancing benefits sensex returns financial planning

Clearly, the path in Scenario 2 is much smoother as compared to Scenario 1.

I don’t care about volatility. I want the best returns.

You may argue that you could have stayed put with an all equity portfolio throughout these 30 years and ended up with Rs 5.41 crores. This number is much higher than either Scenario 1 or Scenario 2. However, you must note equity investments have been a clear winner over the last 30 years. We don’t know if the equity investments will be a winner over the next 30 years by such a wide margin or be a winner at all.

Additionally, don’t ignore the volatility. Standard deviation of annual returns (32.34%) is much higher than Scenario 1 and Scenario 2.  You would have lost more than half your wealth in 2008. You would have lost more than 15% in 6 out of 30 years. Not sure how many of us have the courage to stick with our strategy after witnessing such carnage in our portfolios. I will lose my sleep for sure.

portfolio rebalancing financial planner bangalore SEBI registered investment adviser 1989-2018

You can still afford to ignore volatility of equity when you are in accumulation phase (before retirement). However, volatility is extremely important in a decumulation portfolio (post retirement). A bad sequence of returns in the early part of your retirement and you will struggle during retirement. For more on this topic, refer to this post.

Alternate Scenarios

By the way, it is not that you will always end up with a higher number for an all equity portfolio. If you had started with Rs 10 lacs on January 1, 1994 and invested the entire amount in the index fund, you would have ended up with Rs 1.08 crores on December 31, 2018.

Had you invested in a 50:50 portfolio and rebalanced annually, you would have ended up with Rs 1.13 crores. Yes, a higher corpus with only 50:50 portfolio over 25 years.  I believe 25 years is a long term for most of us. You can call this Rebalancing bonus. Untouched portfolio would have given only 88.13 lacs.

portfolio rebalancing fee only financial planner SEBI RIA bangalore 1994-2018

The reason why this happened was because Sensex returned 9.98% p.a. CAGR during these 25 years. The difference between FD return (8%) and Sensex return (9.98%) is not as wide. Of course, the sequence of returns also played its part.

Buy low and selling high

In any capital asset, the only way to make money is to Buy low and Sell high. There is no other way. With rebalancing, this becomes an automatic exercise.

When the equities do well during the year, you will have to sell equity at the end of the year to stick to your target allocation.

Rebalancing forces you to sell equity when the markets have risen and buy equity when the markets have fallen. Automatic buying low and selling high.

To many of us, rebalancing may look like an option for cowards. However, if you see, this defensive and simple approach of resetting the asset allocation every year, you also end up with a bigger corpus.

Points to Note

I have considered just two assets. You can consider other assets such as gold or international equities as part of your portfolio mix. Adding asset classes will result in better diversification.

Rebalancing helps if the correlation between the assets considered is low. In this post, I have considered fixed deposits give a return of 8% p.a. irrespective of the returns from Sensex. Essentially, I have considered there is no correlation between equity and debt returns. In the real world, that may not be the case. Rebalancing won’t serve much purpose if the correlation between the assets is high. For instance, rebalancing between large cap equities and small cap equities may not serve as much purpose.  Of course, we will have to test this.

The primary purpose of rebalancing must be to reduce risk in your portfolio. Rebalancing may not always result in higher returns. If the returns between the asset classes is very wide as we saw in 1989-2018 example, you will be better off keeping your portfolio untouched or keeping 100% in the higher yielding asset. The problem is you wouldn’t know these returns in advance. Therefore, this can’t be decision factor. Better to start with an asset allocation approach and rebalance at regular intervals.

What is the best asset allocation?

Again, this can only be told in hindsight. Next 30 years can be very different from the last 30. However, 50:50 equity: debt (considering only 2 assets) looks a healthy compromise.  

Your destination is financial security and adequate money for your goals including retirement. There may be many ways to reach there. If the path is too tumultuous, you can quit the journey and give up on your goal. Regular rebalancing can help make your journey comfortable and stick to the investment discipline.

By the way, many times, rebalancing looks like a contrarian call. Selling equity when the markets are hitting new highs every day is not that easy. Therefore, if you can’t do it yourself, seek professional assistance from a financial planner or a SEBI Registered Investment Adviser.

Disclaimer: Registration granted by SEBI, membership of BASL, and certification from NISM in no way guarantee performance of the intermediary or provide any assurance of returns to investors. Investment in securities market is subject to market risks. Read all the related documents carefully before investing.

Note: This post is for education purpose alone and is NOT investment advice. This is not a recommendation to invest or NOT invest in any product. The securities, instruments, or indices quoted are for illustration only and are not recommendatory. My views may be biased, and I may choose not to focus on aspects that you consider important. Your financial goals may be different. You may have a different risk profile. You may be in a different life stage than I am in. Hence, you must NOT base your investment decisions based on my writings. There is no one-size-fits-all solution in investments. What may be a good investment for certain investors may NOT be good for others. And vice versa. Therefore, read and understand the product terms and conditions and consider your risk profile, requirements, and suitability before investing in any investment product or following an investment approach.

10 thoughts on “What is Portfolio Rebalancing? How it helps?”

  1. Instead of 50-50% asset allocation 65% (Equity) & 35 % (debt) what is the end result in last 25 & 30 years ? I am asking because in 50-50% allocation investor has to exercise it manually every year with tax implication but If invested in aggressive balance fund one has to do nothing.

  2. Portfolio management is important for any Investor seeking to achieve his long term investing goals in order to actually monitor his investment and manage the risk accordingly .Thanks for sharing

  3. Excellent Analysis – Thanks Deepesh Sir for your invaluable analysis and 50:50 Portfolio will work for majority of folks with automatic rebalancing every year that yields great along with reduced risk!!

  4. Deepesh,
    Thanks for all your articles. They are super helpful and fabulous. Much appreciated.

    Reg. rebalancing, can you comment something about the impact of the CG taxes? Personally I don’t have an idea how I can think/gauge about the CG impact (overall cost) of rebalancing. So yours thoughts/guidelines would be super helpful.
    1/ Assuming one need to do rebalancing once a year, how strict one needs to be ? Say do we need to do rebalancing for 5% deviation? (say for 50:50 portfolio, equity becomes 52.5%).
    2/ What can be the trigger point for rebalancing? A calendar day or say 10%/15% deviation?


    1. Thiyagu,
      Thanks for the kind words.
      Young investors (with relatively smaller portfolios) can simply get the asset allocation right by adjusting incremental allocations i.e. adjust SIP allocation. Rebalancing (by switching from one asset class to another) is more important for bigger portfolios (big relative to incremental allocations). And that’s where significant tax costs can come in.
      1. There is no need to be extremely strict. and there are no defined rules. 5%-10% deviation is fine. So, if your target is 50%, 55% should be ok. But if your target equity allocation is 70%, perhaps 77% (10% deviation) will become too aggressive. So, you may want to work with 5% deviation. If you are young, you may be ok with wider deviation bands. For old investors, managing volatility is more important. Hence, may use narrower deviation bands.
      2. I believe in market momentum. So, will let things run unless the thresholds are breached. You can use calendar day or deviation or a mix of both. No right or wrong answers here.

      1. Thanks Deepesh. Got few perspectives from your reply. Will think more for my context.
        In my case, CG taxes may get prohibitive. As you mentioned elsewhere, will start seeing my allocation as a range (say 50% – 60%) and will see to it that it doesn’t becomes overtly aggressive …
        PS: I’m going through your other articles. They are deep, yet succinctly explained. Thanks again and kudos to your write ups. .

        1. Thanks Thiyagu.
          Yes, it is ok if you keep it within a comfortable range. We don’t have to be too mechanical about this.

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