Rebalancing a 60:40 portfolio: a two-year worked example

What rebalancing is

You choose a mix, say 60% in equity and 40% in debt. Markets then move the mix for you. After a strong equity year you hold more equity than you planned, which means more risk than you planned. Rebalancing sells some of what grew and buys some of what lagged to bring the mix back.

The usual claim is that this "sells high and buys low". This post tests that claim with two years of invented returns, chosen so you can check every step by hand. They are not forecasts and not any fund's record.

Year one: equity does well

Start with ₹10,00,000: ₹6,00,000 in equity and ₹4,00,000 in debt. In year one, equity returns +25% and debt returns +6%.

• Equity: ₹6,00,000 × 1.25 = ₹7,50,000
• Debt: ₹4,00,000 × 1.06 = ₹4,24,000
• Total: ₹11,74,000. Equity is now 7,50,000 ÷ 11,74,000 = 63.9% of the portfolio, up from 60%.

The portfolio drifted 3.9 percentage points toward equity. Two investors now diverge.

• Investor A does nothing. Holds ₹7,50,000 and ₹4,24,000.
• Investor B rebalances. Resets to 60:40 of ₹11,74,000: equity ₹7,04,400, debt ₹4,69,600. That means moving ₹45,600 from equity to debt (7,50,000 − 7,04,400).

Year two, scenario one: equity falls 15%

Equity returns −15% and debt +7%.

Investor B ends ₹10,032 ahead. B had less in equity when it fell and more in debt when debt earned its return. The "sell high" instinct paid off.

Year two, scenario two: equity rises another 15%

Equity returns +15% and debt +7%.

Now Investor B ends ₹3,648 behind. Taking money off the table early meant owning less of the thing that kept rising.

What the two scenarios show

• Rebalancing is not a return enhancer. It was worth +₹10,032 in one future and −₹3,648 in the other. Which one happens is not something the rebalancer controls.
• It controls risk. Investor A's equity share would have drifted past 63.9% in scenario two (to about 65.5% before any further moves) and would have been hit harder in scenario one. Investor B's portfolio never carried more than the intended 60% at the start of a year.
• The two outcomes are not symmetric here. B's loss in the rising case (₹3,648) is smaller than B's gain in the falling case (₹10,032), but that comes from the invented numbers, not from a rule.
• Taxes and costs are missing here. Selling ₹45,600 of equity units realises gains that may be taxed, which would reduce B's result in both scenarios.

How to rebalance without selling

The cleanest way to move toward the target is to direct new money to the asset class that is below target. A SIP that buys more of the lagging fund brings the mix back without a sale, which is the approach in rebalancing with new money instead of selling. When you do need to sell, remember that a switch between mutual funds is a redemption for tax purposes, as set out in switching mutual funds is a taxable event.

Choosing the target in the first place

The 60:40 split is an example. The right mix depends on your time horizon and on how much of a fall you can sit through without selling at the wrong time; asset allocation by age and the risk profile quiz are the better starting points. Once the target is set, rebalancing is just the rule that keeps you near it.

Reading this

• Every return above is invented for arithmetic. They are not forecasts, and equity and debt will not behave this tidily.
• Taxes, exit loads and transaction costs are excluded, and all of them reduce the benefit of selling to rebalance.
• This describes a mechanism, not a recommendation to hold any mix or any fund.