Importance of Portfolio Rebalancing

In this article, we invested Rs.50,000 in a portfolio of banking stocks. The total amount was allocated amongst the 5 stocks in equal proportion. However since fractional shares cannot be bought, the portfolio weight was a close approximation of the equal weighted portfolio that we wanted to create.

Suppose we revisit the portfolio after a year, the market value of each security within the portfolio will most likely be different, thereby affecting the weightage of the security within the portfolio.

Portfolio summary at the end of year 1:

StockNumber of SharesDay 0End of Year 1
Market PriceNet WorthWeight of StocksMarket PriceNet WorthWeight of Stocks
Annual Returns21.30%

In the case of our imaginary portfolio both PNB and BOI saw exaggerated price movements which resulted in drastic change in their weightage within the portfolio.

One option that we have in this case is to ignore the change in weightage and continue to hold the same number of shares. This strategy will allow an investor to earn good returns only if BOI continues to perform well and PNB continues to perform poorly.

Suppose the investor decides to retain the portfolio weights hoping that BOI and PNB will continue to perform in line with their historical performance. In case of the below example, share price of both BOI and PNB increased during the year. While share price increase is always good news, in this case the portfolio was less affected by the 40% increase in price of PNB and more affected by the only 5% increase in share price of BOI. This was because of the respective weights of the scrip’s within the portfolio.

StockNumber of SharesEnd of Year 1End of Year 2
Market PriceNet WorthWeight of StocksMarket PriceNet WorthWeight of Stocks
Annual Returns21.30%9.2

Hence it is very important to rebalance.

Rebalancing is a form of risk management that will improve the investors risk-adjusted returns over time.

It involves buying and selling a portion of one’s portfolio in order to set the weight of each scrip back to its original state. If an investor fails to rebalance, the more volatile scrip’s in the portfolio will tend to take over and increase portfolio risk.

Assuming the investor chooses the smarter option of rebalancing at the end of year 1, he will have to buy or sell the shares in this order to ensure that the portfolio remains equal weighted.

StockBought on Day 0Position after rebalancingBuy (/Sell)

As can be seen the investor bought 89 shares of PNB to make up for the lost weightage and sold 39 shares of BOI to reduce its weightage within the portfolio. Minor adjustments were made in case of other shares as well.

StockNumber of SharesEnd of Year 1End of Year 2
Market PriceNet WorthWeight of StocksNumber of SharesMarket PriceNet WorthWeight of Stocks
Annual Returns21.30%11.90%

Rebalancing allowed the investor to earn a return of 11.9% on his portfolio, a 2.7% (11.9 – 9.2) improvement compared to him when he had not rebalanced. This is because he now has more exposure to PNB whose prices increased significantly during the year and less exposure to BOI whose price moved by only 5%.

Nobody can predict with certainty the future returns of a security, past performance is almost never an indication of future performance.

By trimming back on winners and buying laggards, an investor is not only “buying low and selling high”, a sure shot way to make money, but also reaping the full benefit of diversification.

By giving up on past gainers the investor is accepting limited upside potential for greater investment security.

Now that we have learnt why portfolios should be rebalanced, lets look at when and how rebalancing should be done.