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Portfolio Rebalancing – What, When, and How?

Rebalancing of a portfolio is a strategy of realigning the securities weights in a portfolio to maintain the target asset allocation and risk profile. It involves selling a few investments and buying to increase investment in existing securities or adding funds to purchase new securities strategically. 

Ideally, rebalancing portfolios is done at regular intervals like once a year or as per target asset allocation. Every investor has to rebalance their portfolio regularly.

portfolio rebalancing
portfolio rebalancing

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 the weighted method of an asset portfolio. For example, at the time of investment, an investor chooses their asset allocation to be 50% in stocks and 50% in bonds. 

The stocks perform well over a period of time, and the equity allocation becomes 65%. At this point, it’s necessary to restore original asset allocation. This is because future gains or losses are highly dependent on stock performance. Therefore, to maintain the right risk-reward ratio, experts recommend the realignment of the assets.

Portfolio rebalancing also means getting rid of the underperforming assets and investing in new ones with better growth potential while maintaining the right asset mix. Also, it helps dispose of investments that are no longer in line with the investment goals.

What Is Asset Allocation?

Asset allocation is the key concept behind determining the investment portfolio of an investor. The asset allocation strategy balances the risk-reward ratio of a portfolio as per the investor’s risk profile, investment horizon, and goal.

In other words, asset allocation identifies the asset classes that generate maximum portfolio returns through minimum risk and volatility. The three primary asset classes are Equity, Debt and Cash, and equivalents. 

Each asset class has multiple financial instruments. For example, equity as an asset class comprises stocks/share and equity mutual funds. Each asset class has a different risk-reward ratio. To strike the right asset allocation is to ensure that the entire portfolio isn’t affected by the market forces. 

Hence diversification is the key. To determine the right asset allocation, it is necessary to understand the income level, preferred retirement age, risk appetite, investment duration, and investment objective of the investor. 

How does Rebalancing work?

Rebalancing of Portfolio works primarily in safeguarding the investor from overexposure to undesired risk. Often rebalancing the portfolio keeps the risk in check with investor’s tolerance levels. The equity performance varies drastically with that of the debt instruments. 

As a result, this will have an impact on the percentage holding. To meet the changing financial needs, the overall risk changes as well. Hence, rebalancing the portfolio to meet the new requirements is a must.

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 might miss out on an excellent market opportunity to rebalance the portfolio.

Tolerance Band Rebalancing

Here, rebalancing to align with original asset allocation is done by the percentage deviation in the asset. Have a 5% threshold, and keep revisiting to check for this deviation and rebalance accordingly. 

For instance, Ms. Dhriti has 30% in Blue chips, 20% is Midcaps, 10% in small-cap, 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.

Who should do it?

A day trader should check his investments daily. 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 should look at portfolio rebalancing every year (at least once).

Investors investing in securities with fixed maturities like FDs, PPF, NPS, or SSY shouldn’t bother about rebalancing. The returns and tenure of investment for these are fixed. And investors need not worry about asset allocation here.

Investors who have a financial advisor who manages their investments need not worry about rebalancing at all.

When should you rebalance?

One can choose the interval for their portfolio rebalancing from the available multiple alternatives. Rebalancing a lot might increase the rebalancing expense like trading costs, tax, etc. But not rebalancing at all might lead to severe losses.

Investors ideally are suggested to rebalance their portfolio once a year. They can make it a habit to rebalance the portfolio on the same day every year. Irrespective of the changes in the portfolio, rebalancing can be done yearly.

There is another way to look at rebalancing. Investors can choose an ideal asset allocation and the deviation from which is accepted. Anytime during their investment journey, if the asset allocation crosses the deviation, the investor can rebalance the portfolio. 

But the problem with this method is that if the market movements are higher than the deviation chosen, then the portfolio rebalancing will have to be done multiple times a year. This might increase the cost of rebalancing.

Hence, it is ideal to monitor the portfolio annually or semi-annually and rebalance the portfolio only when the portfolio is 5-10% away from the target. This will help reduce excessive portfolio rebalancing and, in turn, the rebalancing expenses.

Published on May 22, 2020