Rebalancing portfolio


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The Importance of Investment Portfolio Re-balancing

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Rebalancing portfolio

  3. 3. KROGV D 0DVWHU RI 6FLHQFH LQ )LQDQFLDO (QJLQHHULQJ DQG KDV PRUH WKDQ HDUV RI H[SHULHQFH LQ FHQWUDO EDQNLQJ FRUSRUDWH EDQNLQJ DQG IXQG PDQDJHPHQW , nvesting is never an easy activity for anyone to be engaged in, and it is especially tricky for the retail investor. In the investment world, large institutions with plenty of monies can either employ sophisticated investment strategies with the help of state-of-the-art computers that dissert market information and data right down to micro seconds, or they can employ a huge team of leading strategists or Fund Managers to manage their investment portfolios. So, without the arsenals these institutions have at their disposal, can the retail investor still do well in investing? The answer is YES – if you are a disciplined long term investor. There are actually three free lunches - as I would like to call them - that a retail investor can take advantage of to swing the odds of making monies to their favour. The three free lunches are: In this article, I will explain what rebalancing is and the benefits that come with it. In future Wealth Journal articles, I will expound on “asset allocation” and “time in the market”. What is Rebalancing? Rebalancing involves setting a fixed asset allocation to your portfolio and sticking to it through different financial market conditions. Let’s say you examine your risk profile and decide to invest in a mixture of 70% in stocks and 30% in bonds. As the years go by, your portfolio will drift one way or another. You may drop down to 60% in stocks or rise up to 90% in stocks. The act of rebalancing involves selling or buying shares in order to return to your initial stock and bond ratio of 70%/30%. Hence, every year, regardless of how the markets have moved, you rebalance your portfolio to its original asset allocation.  ŽŠ•‘ȱ–Š—ŠŽ–Ž—ȱ ,19(670(17,19(670(17,19(670(17,19(670(17 X Z E/E' zKhZ /Es^dDEd WKZdK/K Y , s/E' d, Z/',d ^^d K d/KE Z d/D /E d, D Zd 5(%$/$1,1* 285 ,19(670(17 3257)2/,2
  4. 4. ŝŶĂŶĐŝĂů ůůŝĂŶĐĞ Ξ ůů ZŝŐŚƚƐ ZĞƐĞƌǀĞĚ ͮ ϭϱ Why Rebalance? Rebalancing is a way to maintain the risk and reward ratio that you have chosen for your investments. In the example above, doing nothing over the years may leave you with a 90% stocks and 10% bond portfolio, which is much more aggressive than your initial 70% stocks and 30% bond mix. More importantly, rebalancing forces you to buy temporarily under-performing assets and sell over- performing assets (buy low, sell high). This is the exact opposite behaviour to what is displayed by many investors, which is to buy in when something is hot and over- performing, only to sell when the same investment becomes out of style (buy high, sell low). Table 1 on the following page shows that different asset classes perform well over various time periods and no single asset class will consistently outperform others over a long period of time. Hence, having the discipline to harvest gains in a performing asset class and redeploying those gains in an underperforming asset class is the key to reaping higher gains over the long run. ƵŶĚ 'ůŽďĂů ŵĞƌŐŝŶŐ DĂƌŬĞƚ h^ :ĂƉĂŶ ƐŝĂͲĞdž :ĂƉĂŶ ^ŝŶŐĂƉŽƌĞ 'ůŽďĂů ŽŶĚ dŽƚĂů WĞƌĐĞŶƚĂŐĞ ϮϬй Ϯϱй ϱй ϭϱй ϱй ϯϬй ϭϬϬй /ŶŝƚŝĂů /ŶǀĞƐƚŵĞŶƚ ΨϮϬ͕ϬϬϬ ΨϮϱ͕ϬϬϬ Ψϱ͕ϬϬϬ Ψϭϱ͕ϬϬϬ Ψϱ͕ϬϬϬ ΨϯϬ͕ϬϬϬ ΨϭϬϬ͕ϬϬϬ ƵŶĚ 'ůŽďĂů ŵĞƌŐŝŶŐ DĂƌŬĞƚ h^ :ĂƉĂŶ ƐŝĂͲĞdž :ĂƉĂŶ ^ŝŶŐĂƉŽƌĞ 'ůŽďĂů ŽŶĚ ĚũƵƐƚŵĞŶƚ ƚŽ ƌĞďĂůĂŶĐĞ ƵLJ ^Ğůů ƵLJ ƵLJ ƵLJ ƵLJ /ŶŝƚŝĂů /ŶǀĞƐƚŵĞŶƚ Ψϰ͕ϰϭϬ ^ϳϯϴ Ψϭ͕ϯϱϯ Ψϳϱϴ ΨϲϬϯ Ψϯ͕ϲϭϱ After one year, some funds would have appreciated or fallen in value as shown below: ƵŶĚ 'ůŽďĂů ŵĞƌŐŝŶŐ DĂƌŬĞƚ h^ :ĂƉĂŶ ƐŝĂͲĞdž :ĂƉĂŶ ^ŝŶŐĂƉŽƌĞ 'ůŽďĂů ŽŶĚ dŽƚĂů WĞƌĐĞŶƚĂŐĞ ϭϳ͘ϳϱй Ϯϴ͘ϬϮй ϰ͘ϮϬй ϭϱ͘ϲϵй ϰ͘ϵϬй Ϯϵ͘ϰϯй ϭϬϬй /ŶŝƚŝĂů /ŶǀĞƐƚŵĞŶƚ ; Ϳ Ψϭϵ͕ϬϬϬ ΨϯϬ͕ϬϬϬ Ψϰ͕ϱϬϬ Ψϭϲ͕ϴϬϬ Ψϱ͕ϮϱϬ Ψϯϭ͕ϱϬϬ ΨϭϬϳ͕ϬϱϬ ƵŶĚ 'ůŽďĂů ŵĞƌŐŝŶŐ DĂƌŬĞƚ h^ :ĂƉĂŶ ƐŝĂͲĞdž :ĂƉĂŶ ^ŝŶŐĂƉŽƌĞ 'ůŽďĂů ŽŶĚ dŽƚĂů WĞƌĐĞŶƚĂŐĞ ϮϬй Ϯϱй ϱй ϭϱй ϱй ϯϬй ϭϬϬй /ŶŝƚŝĂů /ŶǀĞƐƚŵĞŶƚ ;Ϳ ΨϮϯ͕ϰϭϬ ΨϮϵ͕Ϯϲϯ Ψϱ͕ϴϱϯ Ψϭϳ͕ϱϱϴ Ψϱ͕ϴϱϯ Ψϯϱ͕ϭϭϱ Ψϭϭϳ͕ϬϱϬ Due to the good performance of the portfolio, you decide to invest an additional $10,000 into this portfolio and rebalance it to its initial portfolio allocation (same percentage). So the rebalanced investment should total $117,050 ($107,050 + $10,000). In order to attain your target allocation, you then make the adjustments to the funds in the manner below: After executing the above buy and sell actions, the portfolio will be rebalanced to its initial target allocation. At the start, you have $100,000 capital invested in the following proportion: Let me illustrate with this example:
  5. 5. ϭϲ :Ƶů Ͳ ĞĐ ϮϬϭϭ µ Does Rebalancing Work? Table 2 illustrates the back- testing result of a balanced portfolio of $10,000 invested in 60% global equities and 40% global bonds for 36 years from 1973 to 2009 – with and without yearly rebalancing. A buy and hold strategy, i.e. without rebalancing, in this portfolio would have grown the initial $10,000 to $74,354, translating to an annualised return of 5.7% p.a. This is a decent return for a passive investor who did nothing over the 36 years. However, if the portfolio is rebalanced religiously every year over the same period, the starting $10,000 would have grown to $120,995! Rebalancing actually squeezed out an additional $46,641 as compared to the buy and hold strategy. In terms of annualised return, this portfolio made 7.2% p.a. or 1.5% higher than the buy and hold strategy. Over a long period, the extra 1 to 2% will translate to a significant amount, as illustrated in this example. 7RWDO 5HEDODQFLQJ 7RWDO 5HEDODQFLQJ HDU (QG 3RUWIROLR 3HUIRUPDQFH )RU (TXLW $QG %RQG :LWK ,QYHVWLQJ 2I dĂďůĞ Ϯ͗ WĞƌĨŽƌŵĂŶĐĞ ŽĨ Ă ϲϬй ƋƵŝƚLJ Θ ϰϬй ŽŶĚ WŽƌĨŽůŝŽ ǁŝƚŚ ĂŶĚ ǁŝƚŚŽƵƚ ĂůĂŶĐŝŶŐ ^ŽƵƌĐĞ͗ ŝĂƐƚ ŝŶĂŶĐŝĂů ĚǀŝƐĞƌ DĂƚƌŝdž ƐŽĨƚǁĂƌĞ dĂďůĞ ϭ͗ WĞƌĨŽƌŵĂŶĐĞ ŽĨ sĂƌŝŽƵƐ ƐƐĞƚ ůĂƐƐĞƐ ĨƌŽŵ ϮϬϬϭ Ͳ ϮϬϬϵ ^ŽƵƌĐĞ͗ ůĂĐŬƌŽĐŬ͕ /ŶĨŽƌŵĂ /ŶǀĞƐƚŵĞŶƚ ^ŽůƵƚŝŽŶƐ 5HEDODQFLQJ LV D VLPSOH VWUDWHJ WKDW LV HDV WR H[HFXWH DQG LI FRQVLVWHQWO DSSOLHG RYHU WKH ORQJ WHUP ZLOO DGG WR RYHU WKH DQQXDOLVHG SRUWIROLR UHWXUQ 7KLV H[WUD WR UHWXUQ FRPSRXQGHG RYHU WKH ORQJ WHUP ZLOO DGG WR RXU LQYHVWPHQW FDSLWDO VLJQLILFDQWO ´
  6. 6. ŝŶĂŶĐŝĂů ůůŝĂŶĐĞ Ξ ůů ZŝŐŚƚƐ ZĞƐĞƌǀĞĚ ͮ ϭϳ How Often Should I Rebalance My Portfolio? You may ask, “How often should I rebalance my portfolio?” and “Would more frequent rebalancing add more value to my portfolio?” An article from Financial Planning magazine, which used the 25-year period from October 1977 to September 2002 and a 60% Stocks (SP 500 Index) and 40% Bond (Lehman Brothers Government Index) as the starting and target allocation for a $10,000 portfolio, illustrated the results for various rebalancing frequencies: From Table 3, it can be observed that the various rebalancing periods showed minimal performance differences, although annual rebalancing yielded a slightly better return margin, albeit with a marginally higher standard deviation. Hence, it can be concluded that frequency is not an important consideration when it comes to rebalancing. Whichever period an investor chooses, be it quarterly, semi- annually or annually, the discipline of following the chosen path over a long period and the costs of executing the rebalancing would be the main considerations. Rebalancing Strategies While rebalancing is not an exact science, an investor can adopt the following guidelines when it comes to rebalancing strategies: ♦ Rebalancing at a pre-determined frequency and time, e.g. every year on 30th December. − Rebalancing at exactly the same time each year is easy to remember. ♦ Rebalancing when the current allocation is 5% off the target asset allocation of major asset classes. − For example, if the target equity weighting is 60%, rebalance the portfolio if the equity allocation exceeds 65% or falls below 55%. − Do nothing if the equity weighting is still within the 5% limit. ♦ For rebalancing of smaller positions in sector funds or country funds, adopt a 25% trigger point. − For example, if you have a 5% weight in global resources sector fund, rebalance this fund if the allocation goes above 6.25% or dip below 3.75%. ♦ Rebalance during injection of new funds or during withdrawals. − Changes in liquidity position, be it addition of new funds or withdrawal, is one of the best times to rebalance as you can buy underweighted assets with the new funds or sell overweighted assets when withdrawing. This also minimizes transaction costs. ZĞďĂůĂŶĐĞ ƌĞƋƵĞŶĐLJ WŽƌƚĨŽůŝŽ 'ƌŽǁƚŚ ŽŵƉŽƵŶĚ ƌĞƚƵƌŶ ^ƚĂŶĚĂƌĚ ĚĞǀŝĂƚŝŽŶ ^ŚĂƌƉĞ ƌĂƚŝŽ DŽŶƚŚůLJ Ψϭϱϭ͕ϰϭϰ ϭϭ͘ϰϴй ϭϭ͘ϱϲ ϭ͘Ϭϰ YƵĂƌƚĞƌůLJ Ψϭϱϯ͕Ϭϭϳ ϭϭ͘ϱϯй ϭϭ͘ϱϮ ϭ͘Ϭϱ ^ĞŵŝͲĂŶŶƵĂůůLJ ΨϭϱϮ͕ϮϰϮ ϭϭ͘ϱϭй ϭϭ͘ϱϴ ϭ͘Ϭϰ ŶŶƵĂůůLJ Ψϭϱϱ͕ϵϬϱ ϭϭ͘ϲϭй ϭϭ͘ϲϯ ϭ͘Ϭϱ EĞǀĞƌ Ψϭϱϭ͕ϱϱϯ ϭϭ͘ϰϵй ϭϰ͘ϰϵ Ϭ͘ϴϲ Summary For a retail investor, enhancing your wealth is definitely not an easy task. The key is to be a disciplined long term investor. One of the ways to increase your odds of making monies in the long run is to rebalance your investment portfolio regularly against a buy and hold strategy. Rebalancing is a simple strategy that is easy to execute and, if consistently applied over the long term, will add 1 to 2% over the annualised portfolio return. This extra 1 to 2% return compounded over the long term will add to your investment capital significantly. dĂďůĞ ϯ͘ ΨϭϬ͕ϬϬϬ ƉŽƌƚĨŽůŝŽ ƉĞƌĨŽƌŵĂŶĐĞ ĨƌŽŵ KĐƚ ϭϵϳϳ ƚŽ ^ĞƉ ϮϬϬϮ ^ŽƵƌĐĞ͗ /ďďŽƚƐŽŶ ƐƐŽĐŝĂƚĞƐ ;ĞdžƚƌĂĐƚĞĚ ĨƌŽŵ ŝŶĂŶĐŝĂů WůĂŶŶŝŶŐ͕ĞĐ ϮϬϬϮͿ hƐĞƐ ƚŽƚĂů ƌĞƚƵƌŶƐ ĨŽƌ ^ΘW ϱϬϬ ĂŶĚ ůĞŚŵĂŶ ƌŽƚŚĞƌƐ /d 'ŽǀĞƌŶŵĞŶƚͬƌĞĚŝƚ ŝŶĚŝĐĞƐ͘ ŽŵƉŽƵŶĚ ƌĞƚƵƌŶƐ͕ ƐƚĂŶĚĂƌĚ ĚĞǀŝĂƚŝŽŶ͕ ĂŶĚ ^ŚĂƌƉĞ ƌĂƚŝŽƐ Ăůů ĂŶŶƵĂůŝƐĞĚ͘