1

Rebalancing is generally done by withdrawing money from investments that have a greater percentage of your money than you want, and putting it in investments where you're underweight.

An alternative way of rebalancing is to leave the existing investments alone and make 100% of further investments in the asset class where you're underweight. So, if you want to put 80% of your money in equity, but you have only 65%, then you'd make all further investments in equity until it becomes 80%. This strategy:

  • Saves capital gains tax, which is as much as 31% in India.
  • Saves exit loads. Mutual funds in India charge an exit load if you withdraw your investment in less than 3 years (in some cases).
  • Is less of a hassle to implement, because there are fewer transactions to make.
  • Does less damage if your asset allocation calculations are wrong, say if you missed one of your investments. You are not going to withdraw money when you shouldn't be.

Are there any downsides of the latter method? Are there empirical studies that measure the performance of both strategies?

Keep in mind that asset allocation is just a rough guide. If I aim to have 75% of my money in equity, then 80% or 70% will work just as well.

PS: This is not at at all a dupe of To rebalance or not to rebalance as has been claimed since that question asks whether to rebalance or not, while this one asks how to rebalance.

4

Rebalancing has been studied empirically quite a bit, but not particularly carefully and actually turns out to be very hard to study well. The main problem is that you don't know until afterward if your target weights were optimal so a bad rebalancing program might give better performance if it strayed closer to optimal weights even if it didn't do an efficient job of keeping near the target weights.

In your particular case either method might be preferred depending on a number of things:

  1. Rebalancing is a balance of to stay close to target allocation which you chose for its preferred risk and return properties without paying too much
  2. The danger of straying from your target allocation depends a lot of what you invest in and your risk tolerance
  3. Intuitively, a portfolio of very different assets (bond vs stocks) straying from your allocations can matter a lot more than a portfolio of similar assets (US stocks vs EU stocks)
  4. High trading costs (taxes) means that you should be a more willing to stray from targets and take longer to get back to them as if there were no trading costs you would just always trade back to target.

You can see why there isn't a generally correct answer to your question and the results of empirical studies might very wildly depending on the mix of assets and risk tolerance. Still if your portfolio is not too complicated you can estimate the costs of the two methods without too much trouble and figure out if it is worthwhile to you.

EDIT In Response to Comment Below:

Your example gets at what makes rebalancing so hard empirically but also generally pretty easy in practice. If you were to target 75% Equity (25% bonds?) and look at returns only for 30 years the "best" rebalancing method would be to never rebalance and just let 75% equity go to near 100% as equity has better long term returns. This happens when you look only at returns as the final number and don't take into account the change in risk in your portfolio.

In practice, most people that are still adding (or subtracting in retirement) to a retirement portfolio are adding (removing) a significant amount compared to the total amount in their portfolio. In the case you discribe, it is cheaper (massively cheaper in the presence of load fees) just to use new capital to trade toward your target, keeping your risk profile. New money should be large enough to keep you near enough your target. If you just estimate the trading costs/fees in both cases I think you'll see just how large the difference is between the two methods this will dwarf any small differences in return over the long run even if you can't trade back all the way to your target.

  • Thanks. Agreed with most of your points, which are insightful. A) I updated the question to say that asset allocation is only a rough guide. If I aim to have 75% equity, 70% or 80% work just as well. B) I suppose there's a way to study empirically: start with a data set for 30 years. Determine what percentage of equity gives the highest return at the end of 30 years, assuming yearly rebalancing. Find out if rebalancing with new money gives a higher or lower return, and by how much. C) How do I estimate the costs of these two methods for my portfolio, since I don't know future returns? – Vaddadi Kartick Nov 21 '15 at 7:08
  • Also, do you have any funds without load fees in your list? I'm not sure about in India but in the U.S. a good starting rule is to just never invest in funds with load fees. – rhaskett Nov 22 '15 at 18:33
  • None. Loads have unfortunately become the norm in India. Up to 3% if you redeem your investments before 3 years (for some funds), after which the load doesn't apply. – Vaddadi Kartick Nov 23 '15 at 2:42
  • I added a reference to the most reasonable way I've found of really optimizing rebalancing trades. The solution it mentions is not worth the time it would take to build as your fees make this problem really one-sided, but this is the most simple explanation I've seen for how to understand the problem of rebalancing in terms of both returns and risk. – rhaskett Nov 23 '15 at 19:10
  • Regarding my example of measuring the effect of rebalancing on returns over a 30-year historical period, we could instead measure risk-adjusted return. Or the maximum return one can get with the condition that the portfolio can never dip more than 20% (say) below the original amount. In either case, we'd first determine the optimal asset allocation with yearly rebalancing, with the benefit of hindsight, and then compare the effect of rebalancing only with new money, to derive a percentage by which the latter underperforms. – Vaddadi Kartick Dec 1 '15 at 12:13
4

There will quickly come a time when buying to rebalance is impractical. Consider, you save 10%, and at some point, you have 5x your income saved. (you earn $50K and have accumulated $250K). A simple allocation, 50/50, so $125K stock, $125K bonds. Now, in a year the market is up much over 4%, your $5K deposit will not be enough to balance. Earlier on, the method may work just fine, later on, not so much.

Edit - The above is an example, to show that there will come a time when deposits are not enough to rebalance. The above single year produces a 52/48 split, and the rebalance deposits more than 2 years. If the market continues to rise a reasonable amount, 2 years later you are even more out of balance, perhaps 56/44. I chose reasonable numbers as a starting point, just 5X income saved, and a 10% annual deposit. In the end, you can waive off any divergence from your target. That's your choice.

  • Even if there's been an year in which stocks go up 10% and bonds go up 1%, stocks go up to 52% of your portfolio, which is close enough to 50% to not matter. I'd also be fine with 60%. Target allocations are approximate, after all. It's not as if anyone can prove that 52% makes you less likely to reach your financial goals than 50%. – Vaddadi Kartick Nov 21 '15 at 3:48
  • I agree that the bigger your portfolio becomes relative to how much you can invest in a given month, the longer it takes to rebalance with new money. But that may still be good enough. In this example, though it takes 2.25 years to rebalance with new money, your asset allocation is still close to 50%, so it's good enough. – Vaddadi Kartick Nov 21 '15 at 7:22
  • Regarding your edit, I see your point now. Upvoted. – Vaddadi Kartick Dec 1 '15 at 12:10
  • 1
    Much appreciated. I continue to work on my writing, explaining what I'm thinking to pass an idea along. Not always easy, but an enjoyable journey. – JTP - Apologise to Monica Dec 1 '15 at 13:38
2

Yes, rebalancing with new money avoids capital gains taxes and loads (although if you're financially literate enough to be thinking about rebalancing techniques, I'm surprised to hear that you're invested in funds with loads).

On the other hand, if it's taking you years to rebalance, then:

(a) you are not rebalancing anywhere near frequently enough. Rebalancing should be something you do every 6 months or 1 year, such that it would take only a few weeks or maybe a month of new investment to get back in balance.

(b) you will be out-of-balance for quite a long time, while the whole point of the theory of rebalancing is to always be mathematically prepared for swings in the market. Any time spent out of balance represents that much more risk that an unexpected market move can seriously hurt your portfolio.

You should weigh the time it will take you to rebalance the long way (i.e. the risk cost of not rebalancing immediately) vs. the taxes and fees involved in rebalancing quickly. If you had said that it would take you only a couple weeks or a month to rebalance the long way, I would say that the long way is fine. But the prospect of spending years without a balanced portfolio seems far more costly to me than any expenses you might incur rebalancing quickly.

Since it's almost the end of the calendar year, have you considered doing two quick rebalances, one this year, and another in January? That way half of the tax consequences would happen in April, and the other half not until the next April, giving you plenty of time to scrounge up the money. Also, even if you have no capital losses this year with which to offset some of your expected capital gains, you would have all of next year to harvest some losses against next year's half of the rebalancing gains.

  • A) I updated the question to say that asset allocation is just a rough guide. If I aim to have 75% of my money in equity, then 80% or 70% will work just as well. B) As you can see from the comment at JoeTaxpayer's answer, even if it takes 2 years to rebalance, the portfolio was never far from the desired allocation to begin with. C) Exit loads are common in India. D) Dec vs Jan makes no difference for tax, in India. – Vaddadi Kartick Nov 21 '15 at 7:27

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