Strategic Asset Allocation & Rebalancing: The Back Bone of your Portfolio

Almost every investor is aware that optimal asset allocation is at the secret to successful long term wealth creation. But in this journey, there are times when the portfolio needs to be rebalanced such that the original spirit of the asset allocation is not lost. However, it is often seen, that investors tend to overlook the importance of portfolio rebalancing. Here, we will try and understand why asset allocation and rebalancing of portfolio at periodic frequency is a necessary step. Historical data shows that asset allocation and rebalancing actually works and aids in reducing portfolio risk and helps make reasonable returns.

To understand this, let us consider an investment made between December 2006 to December

2014. Here, the assumption is an investment amount of Rs. 1 lakh divided equally between equity and debt. The equity allocation is made in S&P BSE Sensex while the debt allocation is made in a leading short term bond fund. Thereafter, the portfolio is rebalanced on a half yearly basis.

Portfolio Rebalancing

The portfolio of Rs. 1 lakh was rebalanced every six months, i.e. the allocation to both equity and debt was rebalanced to 50- 50. This rebalancing is generally achieved by putting fresh money in the asset class which has corrected and bring the percentage allocation to the desired level. If this is not possible, then rebalancing is achieved by selling the asset class which has rallied and deploying the gains in the other asset class.

For the sake of comparison, if an investor had invested the entire sum of R. 1 lakh in Sensex for the time frame under consideration, the return would have been to the tune of a CAGR of 9.01% while a well performing short term debt fund at the same time would have delivered a CAGR of 9.53%. However, if this allocation was rebalanced on half yearly basis, the investment experience would have better with the portfolio delivering a CAGR of 10.43% i.e. higher than both asset classes if invested individually.

Even when it comes to the risk profile, a rebalanced portfolio presents moderate risk. This is in comparison to equity which has a higher risk profile and debt which has a lower risk profile. By being equally invested in both equity and debt, the overall risk profile of the portfolio is neutralized. Historical return profile shows that such a balanced portfolio also has the ability to generate higher returns. In effect, adhering to asset allocation offers higher returns at lower risk.

Benefits of Asset Allocation

Risk Management: By rebalancing, an investor ensures that the fresh investment is going into an asset class which has attractive valuation and is not overpriced. This is reason why asset allocation is one of the most effective methods of risk management.

Enables to Buy Low, Sell High: While every investor aims to buy low and sell high, rarely does anyone succeed at it. This is largely because behavioral challenges of greed and fear that an investor is constantly challenged with.

Given that asset allocation is a mathematical model, the confusion part is taken care of easily.

Discourages Market Timing:

Investor spent a lot of time trying to predict the future movement of the market. But a landmark research by Brinson, Hood and Beebower, “Determinants of Portfolio Performance” (1986, 1991) argues that asset allocation accounts for 94% of the variation in returns in a portfolio, leaving market timing and stock selection to account for only 6%.

To conclude, while asset allocation may not look fancy, it is the simplest and the most effective way to balance out of the overall risk of the portfolio, thereby leading to higher portfolio returns over the long term.