09 November 2013

Saturday, November 09, 2013

Turn on any business TV channel, and it is impossible not to be in awe of wise sounding financial analysts giving opinion about the market and stocks. Fundamental analysts will be analyzing economic conditions and their impact on a company’s business, and technical analysts will be analyzing chart formations. I don’t understand any of it because I am no Warren Buffett. And I don’t want to spend all my time figuring all this out. Do you feel the same?

Let me spell out my constraints, see if these are applicable to you:

  • I am not a finance wizard, I don’t earn my living by investing
  • I want my money to work and beat inflation instead of rotting in saving bank account or fixed deposits, but I am not chasing maximum return, I just want returns to meet my financial needs
  • I want to live my life and not spend it all just watching my investments
  • Based on my personal experiences and that of people around me, I don’t quite trust financial advisors; only thing guaranteed with them is their fees or commission, and they seem to suggest investments to maximize their income, not mine.

I call myself passive investor. My solution has been to practice passive investment philosophy of asset allocation and rebalancing, in a detached, systematic, methodical way. And I will explain it in this article. It has served me well, but I must caution that it might not be suitable for you, and it is not a financial advice of any kind. You should not blindly follow anything or anybody, not even Warren Buffett. Evaluate it, find out whether it makes sense to you. First and foremost, I advocate financial literacy.

Asset Allocation

First step is to understand your risk appetite, financial goals and timeframe. Evaluating this troika of risk-return-liquidity will help you in picking a suitable mix of asset classes. I keep aside contingency funds and short term needs in low-risk cash-equivalents (fixed deposit, liquid mutual funds), and medium term needs in medium-risk debt/bond mutual funds. Only for long term needs, I use asset allocation and rebalancing.

Figuring out risk appetite is quite hard. How am I supposed to know how I will feel if my portfolio falls by 10%, 20%, 30%, 50%? So I follow a popular rule of thumb for asset allocation: if your age is x, then portfolio asset allocation should be x% in medium-risk assets (bonds, gold) and (100-x)% in high-risk assets (equity, real estate). It is a good rule to start with, and based on learning and experience, one can fine tune it. The basic premise is that risk appetite decreases with age.

Let’s take a concrete example. Say, the age is 30 years, and for sake of simplicity, only investment options are bonds and equity. The suggested asset allocation is: 30% in bonds and 70% in equity.


Rebalancing is a technique to maintain the desired asset allocation. Let’s say, one year back, you have invested ₹1 Lakh in chosen asset allocation of 30:70, i.e. 30% in bonds and 70% in equity. Suppose in last one year, bonds and equities gave 8% and 15% returns respectively. That will take allocation to 28.70 : 71.30 as shown in following table. To bring it back to 30:70, you will need to sell ₹1,470 worth of equity and invest that amount into bonds.

Asset Desired Allocation Investment Growth Current Value Current Allocation Rebalance Post Rebalancing
Bonds 30% ₹ 30,000 8% ₹ 32,400 28.70% ₹ +1,470 ₹ 33,870
Equity 70% ₹ 70,000 15% ₹ 80,500 71.30% ₹ -1,470 ₹ 79,030
Total 100% ₹ 1,00,000   ₹ 1,12,900 100% ₹ 0.00 ₹ 1,12,900

Let’s see what would have happened if during last equity has fallen by 15% (instead of rising):

Asset Desired Allocation Investment Growth Current Value Current Allocation Rebalance Post Rebalancing
Bonds 30% ₹ 30,000 8% ₹ 32,400 35.26% ₹ –4,830 ₹ 27,570
Equity 70% ₹ 70,000 -15% ₹ 59,500 64.74% ₹ +4,830 ₹ 64,330
Total 100% ₹ 1,00,000   ₹ 91,900 100% ₹ 0.00 ₹ 91,900

Rebalancing would require selling ₹4,830 worth of bonds, and investing that amount in equity. As you probably noticed, the rebalancing strategy forces to book profit in the asset class that has gone up, and invest in the asset class gone down (buy when low, sell when high).

Rebalancing Triggers

There are different tactics for triggering rebalancing. The example above is when rebalancing is done after a year, that works fine since it avoids short term capital gains that are taxed at higher rate. But you can also pick 6 months or 15 months. Whatever period you pick, do it with discipline. Doing it at gap lesser than 3 months is futile, it just increases time overhead and transaction cost.

Another trigger that I use is the imbalance threshold of 5%. When the gap between desired and actual allocation for a asset class is more than 5%, I rebalance. For example, when my equity allocation goes above 75% or below 65%, I rebalance.

Rebalancing along with further investments or withdrawal

If you are in accumulation or withdrawal phase of your investments, i.e. you are putting in or withdrawing some amount every month from your investments, you can incorporate rebalancing into it such that after putting-in or withdrawing, your portfolio is at the desired asset allocation. That reduces transaction costs as well as potential tax outgo.

Let’s take the example above, and suppose you were investing ₹10,000 at the current month, you would need to invest ₹4,470 in bonds and ₹5,530 in equity:

Asset Desired Allocation Investment Growth Current Value Current Allocation Invest Post Rebalancing
Bonds 30% ₹ 30,000 8% ₹ 32,400 28.70% ₹ +4,470 ₹ 36,870
Equity 70% ₹ 70,000 15% ₹ 80,500 71.30% ₹ +5,530 ₹ 86,030
Total 100% ₹ 1,00,000   ₹ 1,12,900 100% ₹ +10,000 ₹ 1,22,900

Similarly if you were withdrawing ₹10,000 the current month, you would need to withdraw ₹1,530 from bonds and ₹8,470 from equity:

Asset Desired Allocation Investment Growth Current Value Current Allocation Withdraw Post Rebalancing
Bonds 30% ₹ 30,000 8% ₹ 32,400 28.70% ₹ -1,530 ₹ 30,870
Equity 70% ₹ 70,000 15% ₹ 80,500 71.30% ₹ -8,470 ₹ 72,030
Total 100% ₹ 1,00,000   ₹ 1,12,900 100% ₹ –10,000 ₹ 1,02,900

You do not need to do these computations every month by hand, instead it can be incorporated into an excel sheet.


My passive investment strategy for long term investment has two parts: asset allocation and rebalancing. Asset allocation is to decide weight of various asset classes in the portfolio based on risk profile. I use x : (100-x) thumb rule for asset allocation between medium : high risk asset classes. Rebalancing is to keep portfolio at desired asset allocation by selling/buying asset classes that have gone above/below their allocation percentage. Rebalancing can be done periodically or at some imbalance threshold. Further investing or withdrawal can be folded into rebalancing to save transaction cost and taxes.

In the next article, I will share an Excel sheet to automate asset allocation and rebalancing. In future articles, I will discuss investments in various asset classes such as bonds and equity.

Have you used asset allocation and rebalancing? Please share your thoughts and tips in comments.

Older Post
This is the most recent post.

What do you think?

Post a Comment