Re-Balancing

Monitoring and Re-balancing

New Year wishes to all my dearest Readers. I am back with some more Portfolio fundas. After looking up my previous blog on what IPS is all about and having done some basic asset allocation across different asset classes, we come to a very important juncture of the process knows as Monitoring and Re-balancing.

This step of the investment process (for that matter any process of the world) which comes at the end of the cycle is one of the very crucial parts of the investment theory. For me if you miss this you are doing injustice to all the prior steps. From a layman’s view this is the one step which looks into the outcome which was desired at the beginning of the process and compares it with the actual outcome and tries to match them. In case of any divergence, one identifies the changes required to attain the desired goal.

With this preamble let me directly dive into the core of the topic, Monitoring and Re-balancing from a portfolio perspective. To start with, let me answer some basic questions like, Why do we need to Monitor a portfolio which is designed after so much hard-work. The only reason is “Changes”:

  • changes happening in individuals “Need and Circumstances” like changes in liquidity requirement or changes in time Horizon,
  • changes in “Capital Market condition”
  • changes in “Asset allocation happening due to changes in asset prices”.

But more important is how do we Re-balance our portfolio once we observe the change. Most of the time, when we come across the term Re-balancing, it is with reference to changes in Asset Allocation mix happening due to fluctuation in the Market prices of Asset.

When you look at your individual investment as a part of the whole portfolio, you will see that as the prices of the asset keep changing it causes your asset allocation to change. Suppose you started with a 60-40 ratio investment in stocks and bonds (which was designed considering your risk and return objective). Now suppose your investment increases by 20% at the end of the year. This increase causes the your asset allocation mix to change to 65-35 (roughly). So, now you are away from the ratio which was desired for you. We need to constantly keep monitoring the portfolio so it doesn’t go out of the desired range.

  • You can either set a fixed interval (Monthly, Quarterly or Yearly) wherein you can check your portfolio’s status to see if its within the desired range. This is known as “Calendar Re-balancing”.
  • Another way is to Re-balance it when ever it moves outside the desired range by a fixed threshold (say a threshold of +/- 5%), this is known as “Percentage of Portfolio” method.
  • The problem with second option is that you have to have constantly monitor the portfolio to check if the threshold limit has been violated or not. But it comes with the advantage that you always remain within the desired range. Whereas in the first re-balancing option, between the two calendar dates your portfolio may move out of the desired range drastically but the cost of constant monitoring reduces.

    Now the interesting part: let me ask you a very simple question. Suppose you take a position in any stock. The possible outcomes are that it may go up or go down or stay near the current price. Assume prices moved up by 10% What will be your action? Will you sell your investment (booking your profit) or will you buy more of the stock treating it as a good hunt or do some partial booking and stay investment? But before taking any of this action do you ever incorporate your view of the overall market into your investment decision and then take the decision?

    Usually, the answer is “No” in case the prices shoot up and “Yes” in case the prices shoot down. When prices go up most of us look into our investment in complete isolation and take complete credit of the performance boast and try to book our profits without thinking about the overall Market scenario. In the reverse case, when prices move southwards we blame the market and stay invested. Wouldn’t it be great if we had done the reverse in the above scenario?

    Suppose the overall market is going up and your stock is also part of the rally, and assuming your view about the overall market is bullish, wouldn’t it make more sense to buy more of the good stock in such a market and when the overall market is bearish,  wouldn’t selling the stock be more of an intelligent move then just staying invested hoping for the market to turn the tides and waiting for our buying price to come?

    It all depends on your view of the overall market. The view combined with the action taken gives rise to different Re-balancing Strategies.

    • If you think the market is just moving in a range, buying more of the stocks when the market falls and selling them when the prices go up is the better strategy. This strategy is given the name of “Constant-Mix” by investment gurus.
    • If you think the Markets are headed in one direction, upward or downward, then we should buy more stock when the prices go up and start selling when the prices keep falling. This strategy is given the name of “Constant-Proportion” (CPPI).
    • After investment if you do not monitor or re-balance your portfolio, then the strategy you are following is “Buy-and-Hold”, where once you are invested you keep holding the asset irrespective of the price fluctuation.

    A buy-and-hold strategy has been called a linear investment strategy because portfolio returns are a linear function of stock returns. The share purchase and sales involved in constant-mix and CPPI introduces non-linearity in the relationship. The relation between portfolio return and stock returns are concave for constant-mix, since the return increases at a decreasing rate and reduces at increasing rate. In contrast CPPI strategy is convex: the portfolio return increases at increasing rates and decreases at decreasing rates. Buy-and-Hold is also known as “do-nothing” or “static strategy” whereas the other two are known as “do-something” or “dynamic-strategy“.

    To conclude our discussion on Re-balancing Strategies, i will say that in a strong bull or bear market, CPPI outperforms Buy-and-Hold, which outperforms Constant Mix and the priority gets reversed in a market characterized more reversals than by trends.

    Happy Trading!

Amit Lalan

Amit Lalan

Amit holds a Finance MBA degree and has cleared all 3 levels of CFA exam. He loves to read books and listen to music.