Asset Rebalancing

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Main Ideas:

  1. In a well-diversified portfolio, the individual investments are expected to generate a certain rate of return based upon their characteristics and risk profiles.

  2. The returns of different asset classes in a short-term cannot be known in advance. And the markets (both debt and equity) can have significant volatility so as to throw the investors off track. In other words, the short-term performances of assets are Unknown unknowns.

  3. Over longer periods of time, it has been shown that Regression to the mean occurs for the major asset classes. In Jason Zweig's words - “Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.” Link.

  4. By rebalancing, we are actually selling the asset class which has gone up, while buying the one which has gone down. It is the idea of Buying Low, and Selling High. Although, in practice, it is quite difficult to do for most people.

Methods of Rebalancing:

1. Calender Method – You do your Asset rebalancing on a monthly, quarterly, yearly, 2/5 yearly basis. Or you do it daily (David Swensen used to do it daily in his Yale Endowment portfolio, largely because that portfolio did not incur any taxes). There have been few studies which have shown that the frequency of rebalancing, as such, does not have any statistically significant effect over the overall return of the portfolio, provided you do the rebalancing. (I cannot get reference for that right now).

2. Percentage Method – In this, whenever the particular asset goes beyond a set percentage value, the portfolio is rebalanced regardless of the last time it was done.

Another classification can be:

1. By Buying alone – For people who are in period of accumulation / investing money, the balancing can be done by investing amounts in which different amounts are invested into the different assets so as to bring the total amounts in the desired percentages, without ever needing to sell from one. This works best in terms of taxation, because there are no realized gains.

2. By buying and selling – This works for people who have set themselves multiple fixed SIPs. Every year or so, they check the various asset values, and then sell from the higher value asset class to buy from the lower value asset class (or by simple switching, if that is possible).

3. By selling – This works for people who are in the Income generation group and who have to sell assets to get regular income. These people can sell from the higher value asset to rebalance towards their desired asset allocation.

Which is better? Statistically, none. It just depends on the individual investor on what is most comfortable to him. The best frequency is the one which one can do consistently and which hurts the minimum in terms of taxation.

Personally, I use the Buying alone and Calender method.

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