Updated on: June 13, 2021 ; Investments
Background:
We have covered 7 stock portfolio strategies so far. This one will be the 8th one in the series where we will cover the second part of equal weighted portfolio with rebalancing with a different stock selection strategy.
In the first part of equal weighted portfolio with rebalancing, we had selected the same set of stocks that we had in the first three parts of this series.
In the article, we will select the stocks that we had in the 4th article. If you have already read the last article on equal weighted portfolio with rebalancing and the 4th article, then you can skip forward to the ‘Comparative study’ section.
Portfolio selection:
This is section is similar to the one in equal weighted portfolio – Part 2. So if you are familiar with the rest of the process, you can skip reading this section.
Last time we had picked up the stocks that were part of the original Sensex (in 1986) and were still in the Sensex 18 years later (in 2003). This took care of choosing the companies that had stood the test of time and had shown some resilience. This implied that most of them have strong fundamentals and a better chance of surviving the next few decades.
But what we might have missed out on is the chance of tapping into new-age companies that did not exist during the initial days of Sensex and maybe have a better chance of compounded growth in the future. For instance, there were no technology companies or banks in the original Sensex.
So, in this article, we will shortlist our portfolio of stocks from the Sensex of 2003 only. We would be looking back at no other year for this. The 30 stocks in the Sensex of 2003 would be our sole bucket of stocks to choose from.
So, to keep the stock selection unbiased, we will use some very basic rule for the creation of our equal weighted portfolio. We simply choose the top stocks of Sensex by market capitalization, as of March 2003.
Following the same trend as earlier, we will be analysing two scenarios. In the first scenario (Scenario 8a), we choose the top 5 stocks, and in the second scenario (Scenario 8b), we choose the top 8 stocks. These are chosen based on the market capitalization of the stocks.
Methodology for equal weighted portfolio with rebalancing
Since we are using the same stock/portfolio selection criteria as scenario 4a and 4b, we will be using the same set of stocks in our portfolio. They are:
- ONGC
- Reliance Industries
- Hindustan Unilever
- Wipro Limited
- Infosys Technologies
- Indian Oil Corporation
- ITC
- State Bank of India
We will be analysing two scenarios in this 8th part of the multi-part series on stock portfolio investment strategy. As you already know, this part is dedicated to an equal-weighted portfolio, so both scenarios will have equal-weighted portfolios.
In the first scenario, we construct our portfolio with the top 5 stocks only. That means the first portfolio (Scenario 7a) consists of ONGC, Reliance Industries, Hindustan Unilever, Wipro Limited, and Infosys Technologies.
The second portfolio (Scenario 8b) consists of all the 8 stocks listed above.
Now Equal-weighted means that we invest an equal amount of money in each stock in our portfolio.
We assume that we had a corpus of 100,000 rupees to start in March 2003. So in ‘Scenario 8a’ where we picked 5 top stocks, we allocate 20,000 rupees to each stock. And in ‘Scenario 8b’ where there are 8 stocks, each stock gets 12,500 rupees as the initial investment.
We compare both these scenarios with the third case. This third case serves as the base case, where the entire 100,000 rupees is invested in the broad index, i.e. Sensex.
Now, I will be talking about the point that makes this strategy different from the previous ones. The point is rebalancing.
At the end of March each year, we equally redistribute the entire corpus/investment across the stocks in the portfolio. What it means is that, at the end of March of any year, we pull out the money by selling the stocks and use that money to redeploy an equal amount of money into each stock.
Suppose the total corpus grew to 200,000 at the end of March in a particular year, then under ‘scenario 8a’, each stock gets get 200,000 / 5 = 40,000 and in ‘scenario 8b’ each stock gets 200,000 / 8 = 25,000 after redistribution. We call this as rebalancing.
We repeat this exercise each year at March-end without fail.
Now, since we are pulling out money every year, there will be some costs involved. The two major cost components are the transaction costs and the capital gains tax. Now because the money is pulled out after 1 year, you will be charged long term capital gains tax instead of short term capital gains tax. If you are not familiar with these cost components, then don’t worry too much. I will provide all the necessary information you will need to understand the rebalancing strategy.
Transaction charges and other regulatory taxes apply whenever you buy or sell stocks. This applies to the total value of the transaction. We have assumed this to be 0.25%.
Next, you have to pay capital gains tax if you make a profit by selling stocks. we have considered the tax rate to be 10%, which is the prevailing rate today. Please note, these charges are subject to change based on revised government policies and regulations.
According to the current rules, only profits above 100,000 will be taxed at 10% for long term capital gains tax. This is slightly different from the way we made the tax calculations last time. We choose an approximate, and conservative path last time. This time we have tried to be closer to the accurate cost figures.
Just to re-iterate, in rebalancing, we take out the relative gains made in the stocks that have performed better than the rest. Then, we distribute these gains among the stocks that have performed worse relatively. So that each stock has an equal capital allotment after rebalancing.
This is done with the view that each stock in the portfolio will eventually do well in the long run. The interim highs and lows will provide opportunities to buy and sell. Investors can sell the stocks when they are relatively highly-priced, and buy them back when they are relatively cheap.
But in our strategy, we don’t do this activity too frequently. We have pre-decided the timing and frequency of rebalancing. We do it every year at March-end without any changes or exceptions.
Also, we do not add any additional corpus or withdraw money out of it. So it is like a lump sum or one-time investment, but with annual rebalancing.
Now, that we have understood the concept of rebalancing, let’s see how did these scenarios performed in the past.
Comparative study:
Take a look at the tables below. The first table summarizes the performance of the corpus invested in Sensex as of March 2021. You must be familiar with this table already if you have read any of the previous articles in this series.
The next two tables summarise the performance of the two scenarios (8a and 8b).
One point to note is that the portfolio values at the last point of observation (Final investment value), i.e. on March 2021 are just before rebalancing. This is to show the value of the portfolio before the transaction charges and the taxes apply. The charges for rebalancing were deducted at the start of the year, so there is no need to deduct it again at the end of the year.
Also, note that the number of shares has changed for each stock over the investment period.
What we see is that both the scenarios have done well when compared to the Sensex.
Scenario 8b grew close to 25 times (CAGR of 19.7%), whereas scenario 8a grew more than 27 times (CAGR of 20.1%).
Now, look at the gain factor for each stock in both scenarios and compare it with the Sensex. Each stock has individually performed better than the Sensex except for Hindustan Unilever. So, an equal-weighted portfolio with rebalancing definitely has some merits as an investment strategy.
It also seems from these numbers that the portfolio with a lesser number of stocks has performed better. We will revisit this point after we have looked at the chart below.
But before that, let’s compare these numbers with the previous well-performing strategies that did not have rebalancing. Have a look at the tables in the equal-weighted portfolio and equal weighted portfolio with rebalancing.
This equal-weighted portfolio with rebalancing has not performed that well as the last rebalancing portfolio. The only difference between the two was the selection of stocks. Even if there are a few common stocks in both the rebalancing strategies, the final numbers are very different.
So, this brings out the importance of stock selection in a rebalancing portfolio. It is not just the performance of the individual stocks that matters, but also the interaction of stock prices with each other. It benefits the rebalancing strategy if the prices of individual stocks move in opposite directions.
As you know, this is just a snapshot of the portfolio performance. So to understand it a little better, we will look at the monthly performance of the equal-weighted portfolio with rebalancing over the entire investment period.
These numbers have a very interesting story to convey again. According to the tables above, ‘Scenario 8a’ was our best performer. But based on the chart, ‘Scenario 8b’ performed better than ‘Scenario 8a’ for over 17 years.
In fact, till 2008, Sensex performed better or performed at par with the other two scenarios.
So, even a higher number of stocks in a portfolio can have better performance than a portfolio with a lower number of stocks.
Final remarks:
Rebalancing does give you a good mechanism to increase the value of your equal-weighted portfolio. But the success of it relies heavily on the success of each individual stock in your portfolio. It also benefits from the interim swings in the prices of the stocks, we call it volatility.
Comparing these two rebalancing strategies (this one and the previous post), we understand that the price movements of individual stocks play a very crucial role in portfolio performance. It helps rebalancing strategy when stock prices move in opposite directions. This creates opportunities to sell high and buy low.
You will have to regularly monitor the health of your stocks and be ready to change the composition of your portfolio. If you feel that some stocks in your portfolio are beyond redemption, then it would be best to get rid of them, even if it is at a loss.
There is no magic mantra for successful portfolio creation. You have to decide what is right for you.
Choose your stocks carefully !!!