What is Portfolio Rebalancing? Everything You Need To Know 

Managing your investments isn’t a ‘set it and forget it’ task. Over time, markets fluctuate, goals evolve, and the risk you’re exposed to may drift away from what you originally planned. That’s where portfolio rebalancing comes in, a simple yet powerful strategy to keep your investments aligned with your goals and risk tolerance.

Let us understand what portfolio rebalancing is, how portfolio rebalancing works, why it’s important for mutual fund investors, and ways on how to rebalance an investment portfolio.

What is Portfolio Rebalancing?

Portfolio rebalancing is the process of reviewing and restoring the asset allocation of one’s portfolio to its target allocation. In other words, rebalancing is a method for managing an asset portfolio that involves weighting assets.

Rebalancing brings things back on track by selling a portion of the overgrown equity allocation and moving that money into debt instruments. This keeps your risk profile stable and protects you during market downturns.

Now, what is rebalancing in mutual funds?

When you apply this concept specifically to mutual funds, it’s called mutual fund portfolio rebalancing, a must-do for anyone invested in a mix of equity, debt, and hybrid mutual funds.

For example, let’s say you started with 60% in equity mutual funds and 40% in debt funds. If your equities perform well over time, your portfolio might become 75% equities and only 25% debt. While this may sound great, it also means you’re taking on more risk than you intended.

How Portfolio Rebalancing Works? 

Let’s break down how portfolio rebalancing works in practice:

1. Set a Target Asset Allocation

Decide how much of your money you want in various asset classes like equity, debt, or gold based on your risk appetite, financial goals, and time horizon.

2. Monitor Regularly

Track your investments at least once a year (semi-annually is even better). See if the actual allocation has drifted significantly from your target.

3. Take Corrective Action

If your equity portion has grown too large, sell a part of it and redirect that money to underweight assets like debt or gold. Alternatively, instead of selling, you can invest fresh money in underweight categories to restore balance.

4. Repeat

Rebalancing is not a one-time exercise. Markets are dynamic, so make it a habit to review and rebalance periodically.

This is the core of how to rebalance an investment portfolio, whether you invest in mutual funds, stocks, or a mix of both.

Popular Portfolio Rebalancing Strategies

There are three strategies; however, none of them will guarantee returns. It’s important to pick the right approach for rebalancing.

Periodic Rebalancing

Decide a time and make sure to revisit investments. Target to revisit investments at least annually. Periodic rebalancing is good as it inculcates discipline and is less time-consuming. However, one drawback is that the investor may miss an excellent market opportunity to rebalance the portfolio.

Deviation-Based Rebalancing

Here, rebalancing is performed to align with the original asset allocation by adjusting the percentage deviation in each asset. Set a 5% threshold and regularly revisit to check for deviations and rebalance accordingly. 

For instance, Ms. Dhriti has 30% in blue chips, 20% in midcaps, 10% in smallcaps, and 40% in bonds, with a tolerance of +/-5% for each asset class. As the holdings move outside the tolerance band, Ms. Dhriti will have to rebalance to reflect the initial composition.

Allocating New Funds

In this strategy, instead of selling the good-performing assets and rebalancing the portfolio, the investor can infuse more money into the portfolio for rebalancing. In other words, to maintain the desired asset allocation, the investor can infuse capital into the required asset class. 

Regular deposits can help in periodic rebalancing and inculcate financial discipline as well. Rebalancing by allocating new funds means that one is positive (hopeful) that the excellent-performing assets continue to outperform.

Importance of Portfolio Rebalancing

Here’s why portfolio rebalancing matters:

• Without rebalancing, your portfolio may get skewed towards high-risk assets, exposing you to losses when markets dip. 
• By selling part of the outperforming asset, you book profits at regular intervals and protect yourself from sudden market corrections. 
• Rebalancing removes emotions from investment decisions. It ensures you buy low and sell high, the golden rule for wealth creation.
• Your risk tolerance and goals change over time. Rebalancing helps adjust your asset mix to match new circumstances, such as nearing retirement or funding your child’s education.

Who Should Rebalance?

An investor shouldn’t try to micromanage or check the investments daily. However, this doesn’t mean investors should invest and forget about it. A regular check on how the investments are performing is essential.

Investors investing in equities and debt like shares, ETFs, mutual funds, bonds, and other debt securities can consider looking at portfolio rebalancing every year (at least once). 

Investors investing in securities with fixed maturities like fixed deposits (FDs), Public Provident Fund (PPF), or National Pension System (NPS) shouldn’t bother about rebalancing. The returns and tenure of investment for these are fixed. 

Final Thoughts 

Think of rebalancing as routine maintenance for your financial well-being. It helps you stick to your risk level, make the most of market opportunities, and move steadily towards your life goals.

Remember, rebalancing doesn’t mean chasing every market move. Instead, it’s about staying disciplined, tuning out the noise, and making rational, timely tweaks to maintain your desired balance of risk and reward. Make it a habit to keep your investments healthy and to secure your future.

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