Portfolio Rebalancing: What Is It and How to Do It

What Is Portfolio Rebalancing?

Portfolio rebalancing refers to the process of changing the allocation to asset classes in the portfolio such that the percentage allocation to each asset class reverts to the base asset allocation. Let us assume an investor has allocated 75% of their portfolio to equity mutual funds and the remaining 25% to fixed income.

In the earlier section, we saw how equity markets outperformed fixed income last year. As a result of this outperformance, the weightage of equities in the overall portfolio would have risen above the base 75% allocation, and the weightage of fixed income would have fallen below the base allocation of 25%.

During portfolio rebalancing, the investor would have to sell some portion of their equity portfolio such that the equity allocation reverts to the base 75% allocation. The sale proceeds would be invested in fixed income. The investor would buy fixed-income securities such that the fixed-income allocation rises back to the base allocation of 25%.

Why Rebalancing Is Important?

Rebalancing investments in a portfolio is important so that there is no overexposure to one asset class. If there is overexposure to one asset class, and that asset class experiences a sudden big fall, the returns on the entire investment portfolio will be affected.

However, if an investor does portfolio rebalancing regularly, even if one asset class falls, the impact on the entire portfolio will not be significant.

The investor may need to reduce exposure to certain asset classes and increase exposure to others based on certain factors. For example, when the financial goal is near, the investor should shift money from equity to fixed income. Similarly, certain events like an individual's marriage, childbirth, taking a home loan, increasing age, any adverse events in the family, etc., may impact their risk appetite for an asset class like equity. In such scenarios, the individual may need to do portfolio rebalancing.

Now that we understand the meaning of portfolio rebalancing, and why it is important, let us look at how to rebalance mutual fund portfolio.

How to Rebalance Your Portfolio?

The portfolio rebalancing can be done by reducing exposure to some asset classes and increasing exposure to others. Let us understand this with a portfolio rebalancing example. Kanchan invested Rs. 1,00,000 in equity and debt mutual funds in the 75:25 asset allocation.

Kanchan allocated Rs. 75,000 in a large-cap equity fund and Rs. 25,000 in a liquid mutual fund. In one year, the equity mutual fund gave a return of 25%, and the liquid fund gave a return of 7%. The value of the equity fund has increased to Rs. 93,750, and the value of the liquid fund has increased to Rs. 26,750.

In one year, the value of Kanchan’s overall portfolio is Rs. 1,20,500. The equity allocation has increased from 75% to 77.80%. The debt allocation has reduced from 25% to 22.20%.

During the mutual fund rebalancing exercise, Kanchan will have to sell some of the equity mutual fund units such that the equity allocation reverts to the base asset allocation of 75%. She will have to reinvest the equity sale proceeds in the liquid fund so that its allocation increases back to the base asset allocation of 25%.

When Should You Rebalance Your Portfolio?

It is recommended that an investor review their investment portfolio once a year. During the review, they may rebalance their investment portfolio if the asset allocation has changed a lot. Apart from the regular annual review, portfolio rebalancing may be required if there is a sudden big change in a particular asset class.

For example, if the equity market has gone up a lot in a short time, and the valuations are much higher than the long-term averages, portfolio rebalancing may be required. Similarly, if there is a sharp fall in the stock market due to some adverse event, you may want to increase equity allocation.

Sometimes, changes in taxation, Government policies, etc., may also require portfolio rebalancing.

Portfolio Rebalancing Strategies

There are three portfolio rebalancing strategies that investors can use. We have already discussed one that involves selling the asset class whose weightage in the portfolio has increased. The sale proceeds are invested in the other asset classes to increase their weightage to the base asset allocation. However, when you sell an asset class, there are capital gain tax implications.

The second way of doing it is by allocating fresh money to the asset class whose weightage has gone down. With fresh money allocation, the weightage of that asset class will increase. The third way is to pause the ongoing allocation to the asset class whose weightage has increased and continue with the ongoing allocation to the asset class whose weightage has gone down. With these two portfolio rebalancing strategies, you will not need to sell anything; hence, there will be no capital gain tax implications.

Rebalanced Portfolio vs Non-rebalanced Portfolio

In a rebalanced portfolio, the base asset allocation will be maintained. A non-rebalanced portfolio will leave you with a higher allocation to a specific asset class and vulnerable to a downturn in that asset class. Also, as the goal timeline nears, a non-rebalanced portfolio faces the risk of the goal remaining unfulfilled if there is a big price correction in the asset class whose weightage has increased.

Timely Portfolio Rebalancing Can Be the Key to Achieving Financial Goals

To maintain the required asset allocation, you should rebalance your portfolio regularly, once a year. If there are important life events that warrant a portfolio rebalance, you should do it. If the financial goal is nearing, you should shift money from equity to fixed-income. Thus, timely portfolio rebalancing to maintain the required asset allocation can help you achieve your financial goals and attain financial freedom.

FAQs

Across Which Asset Classes Can You Diversify Your Investment Portfolio?

Usually, an investment portfolio diversified across domestic equity mutual funds, fixed income, gold, etc., may suffice. However, if someone wishes to diversify further, investments in real estate, international equity, alternative investment, etc. may be considered.

Can My Portfolio Be Rebalanced Automatically?

You may consider investing in hybrid mutual funds like a dynamic asset allocation fund or a balanced advantage fund. The fund manager manages the equity and debt component dynamically in these funds. By investing in these funds, you can let the fund manager handle the task of rebalancing on your behalf.