Last time we saw the performance of 60/40 stock/bond portfolio which comprises NIFTY Index Fund and a liquid fund. To this mix we now add rebalancing.
The table above shows returns from Nifty Buy and Hold from 1990 to Jul 2020. The second column looks at a 60/40 lump-sum portfolio that starts at the same time. This portfolio is not rebalanced. The third column shows the same 60/40 portfolio, which rebalanced YEARLY only if the weights have drifted by more than 5%. If the 60/40 ratio has moved to 70/30, then it sells equity and buys debt. If the ratio has moved to 55/45, then it sells debt and buys equity.
The returns of the 60/40 unbalanced portfolio are lower by 1% almost annually. It also, however, cuts down the risk measured in terms of standard deviation by almost 15% and if the portfolio is rebalanced then by a massive 40%. Rebalancing is a contentious issue and can be subject to parameter risk.
Now let us look at 3-year rolling returns and standard deviations so that we can take care of the starting point bias, which the above analysis may be subject to. The graph below shows that returns dispersion between Nifty B&H, an Index 60/40 portfolio and Index 60/40 portfolio, which is rebalanced every year subject to the weights drifting by more than 5%. The point that stands out is that in the last ten years, the spread between the returns has narrowed.
The returns of the 60/40 portfolio are slightly lower than the B&H portfolio until Covid-19 hit. It, however, cuts down the risk measured in terms of standard deviation by almost 25%. And the drawdown also reduces considerably. Rebalancing is a contentious issue and we will look at that next week.
Now let us look at 3-year rolling return and standard deviation so that we can take care of the starting point bias, which the above analysis may be subject to. The graph below shows the returns dispersion between Nifty B&H, and an Index 60/40 portfolio. The point that stands out is that in the last ten years, the spread between the returns has narrowed.
So have the standard deviation spreads between B&H and 60/40 portfolio narrowed. But the positioning doesn’t deviate as much as returns deviate. The 60/40 portfolio has consistently lower volatility than Nifty B&H.
You get more return per unit of risk in a 60/40 portfolio is TLDR version if you haven’t read the whole article and just glanced at the tables and graphs.
Should one rebalance?
There is no easy answer here. Fortunately, Pascal answers it for me with a different analogy. Pascal argues that a rational person should live as though God exists and seek to believe in God. If God does not actually exist, such a person will have only a finite loss (some pleasures, luxury, etc.), whereas he stands to receive infinite gains (as represented by eternity in Heaven) and avoid infinite losses (an eternity in Hell).
So, Pascal’s Wager it is for me. I would go with rebalancing assuming that in 30-40 year investing time period, there will be a couple of 40-50%+ drawdowns which I will not be able to sustain. If you believe you can endure such periods, please refer to the Rouchefoucald maxim above.
Prof Jeremy Seigel, professor of finance at the University of Pennsylvania’s Wharton School, recently stated that the 60/40 portfolio will not cut it anymore and 75/25 is the new 60/40. You can read it here. Rick Ferri, a well known Boglehead and RIA, however, disagrees with him and says “However, increasing to 75-25 as Siegel suggests could cause a happy 60-40 investor to capitulate during a bear market, which would cause more harm than good.”
But that remains to be seen. We believe in India, a 60/40 portfolio is an excellent starting point for a majority of investors. If after 5-10 years, having seen a cycle or two, they can think about increasing the equity weight.
Two Key Decisions
To summarize, there are essentially two key decisions that as an investor, one must make about asset allocation:
- Asset Allocation: The allocation between stocks and bonds. This depends on your goal, life stage, risk ability and risk tolerance.
- Rebalancing: Maintain a fixed ratio between stocks and bonds or one that varies with market returns. Bogle believes that the fixed ratio or periodically rebalanced portfolio is a prudent decision for most investors as it limits risk, even though the unbalanced portfolio may provide higher returns in the long run.
It’s not too complicated to invest in an index and a liquid fund and keep rebalancing it. The challenge is to keep doing it year after year, with all the noise around you. A systematic rules-based system is essential for this.
We are working on an Index 60/40 product and you can soon expect to hear on this from us.
Disclaimer: Nothing in this blog should be construed as investment advice. This is purely for educational purposes only. Please consult an investment advisor before investing.
 Pascal’s wager is an argument in philosophy presented by the seventeenth-century French philosopher, mathematician and physicist, Blaise Pascal (1623–1662). It posits that humans bet with their lives that God either exists or does not.