Over long periods of time – say 60+ years if one asset class outperforms (equity) over debt, why should you rebalance? or should you re-balance at all?

Re-balancing is not a return enhancing strategy, it is a risk reduction strategy. Risk reduction – at times improves the return, though the logic is IT SHOULD NOT. Re-balancing is also a Regret Reduction technique – a behavioral finance issue. When the market falls, you regret saying “I should have sold”. In hindsight it seems so “obvious” that you missed a golden opportunity. However, your greed or fear stopped you from doing the “what seems now very obvious”. For example the average return in Indian equity markets is say 18% so far (TRI). Let us say you get 27% in equity markets in 2020 and about 7% in debt markets, should you re-balance? what if the returns in 2021 is 14% and 8%? will there be regret? what about transaction costs and tax?

What if 2021 is -11% and 7% in equity and debt? will your answer be different? If it is different you are suffering from “Outcome bias”. I remember telling IFA and the common investor that “a sub-optimal strategy like SIP is better than the perfect trading strategy in your mind”. Asset allocation is sub-optimal just like SIP is sub-optimal. It works for 99% of the population. You will always get advice about ‘value-sip’ or ‘trading with indicators’ or things like that. Nice in theory, but it is sip which is easy to understand, easy to implement, and it works! Again more about behavioral finance and not so much about the math of finance.

So if you take the past 40 years data and show them a portfolio with balancing and without balancing, they are more likely to choose the not balancing portfolio. I daresay it must have given about 2% more CAGR ATLEAST – maybe more. However the question to ask is not that. The question is what would have you done in years like 1993, 1999, 2001, 2008,…would you have sat tight, invested more or bailed out?

To get this 18% cagr from 1979 till 2019 how many sleepless nights were you willing to spend?

How would have you handled regret of 43% crash (1993) ?

Would you have shifted from Midcap to large-cap to small cap….or stuck around with any one index?

Of course index funds and fund managers were not available in 1979, but just wondering whether somebody would have stayed on. I am one of the best candidates for sitting tight. I have sat tight over such long periods of time but even I do not know whether I will be able to sit calmly over the next 30 years. As age increases my own ‘fear’ may kick in. In 1992, I was 30. In 2008 I was still not yet 50. When I am older say 70 will I be able to “not worry”?

So a strategy of being 100% in equity (which worked for me in the past) may not work for me in the future. I may move to a less equity portfolio soon in a systematic manner. No, this is not because it is an optimal investment move, but it is just to control my behavior. I am afraid that ‘Maya’ will soon be at work. What is Maya? In Vashista Yoga sage Vashista / Lord Rama define Maya as “inability to apply all the knowledge that you have in your own life”. I need to protect myself from “Maya”. So I will go for a PPF, annuity, debt funds, bank fd – enough to last for 20 years…as a safety valve. A sub-optimal solution. More relaxing perhaps.