Portfolio rebalancing: Meaning, how & when to do it?

The number one thing that most investors get wrong about investing in mutual funds is that they want to build but not maintain. An initial portfolio make-up that perfectly aligns with your investment goals will not stay that way forever. Portfolio adjustments or rebalancing, much like regular oiling of a car, must be made to ensure steady returns throughout the tenure. Let's get to know what is portfolio rebalancing in detail.

What does portfolio rebalancing mean?

Portfolio rebalancing refers to the act of adjusting the asset allocation in your investment portfolio to ensure that it is best suited to your risk tolerance and investment objectives. The process typically involves redeeming or selling specific assets in an investment portfolio and then reinvesting in other assets. 

Additional Read: All You Need to Know How To Review Your Investment Portfolio?

Why is portfolio rebalancing important?

After understanding what is portfolio rebalancing, let’s discuss why portfolio rebalancing is important:

• It ensures the portfolio is perfectly aligned with your risk appetite and investment goals.
• Over time, certain funds tend to perform better than others, thereby disturbing the portfolio balance. For instance, when the equity markets perform better than the bond market, you are forced to increase allocation in the equity markets. However, such a move exposes you to greater risk than you can tolerate. Portfolio rebalancing helps in restoring this imbalance.

Additional Read: Why it is Required to Diversify Your MF Portfolio

How does portfolio rebalancing work?

Portfolio rebalancing is performed to maintain a desired level of risk and return in your portfolio. It works by balancing the allocation of assets.

Suppose your desired allocation was 60% stocks and 40% bonds. However, stock market gains led to portfolio shifts to 70% stocks and 30% bonds. Now, your risk exposure increases, and you must rebalance the portfolio to maintain steady returns.

To rebalance, you can either sell some overperforming assets and buy more of the underperforming ones or make a fresh investment into the underweighted asset classes. While it is advised to rebalance your portfolio periodically, there is no right or wrong way. You can assess and rebalance your portfolio every month, quarter, or year. Alternatively, you can rebalance it when it crosses a specific threshold, like dropping over 5% from its target.

The goal of portfolio rebalancing is to keep the portfolio aligned with your financial goals, risk tolerance, and investment horizon. While rebalancing may involve transaction costs and tax implications, it helps prevent overexposure to volatile assets and reinforces a disciplined investment approach. In the long run, it can enhance portfolio stability and improve risk-adjusted returns.

Advantages and disadvantages of portfolio rebalancing

Portfolio rebalancing involves rebalancing investments to maintain your desired asset allocation. The table below depicts its advantages and disadvantages:

When to rebalance your portfolio?

Often, investors are confused as to when they should rebalance their portfolio. Simply put, there are two main ways in which portfolio rebalancing can be approached:

• At fixed intervals

Investors can choose to rebalance their portfolio at fixed intervals that can be monthly, semi-annually, or annually.

• When it’s needed

Alternatively, investors can rebalance their portfolios as and when needed, i.e., when they are clearly out of balance. 

In most cases, rebalancing the portfolio once or twice a year is sufficient to prevent the portfolio’s value from becoming extremely volatile.

Step-by-step guide to rebalance portfolio

Portfolio rebalancing may not seem like an easy activity for beginners due to a lack of understanding of the various stock market investment tools and the process of making portfolio amendments. This step-by-step guide will help you learn how you can bring your portfolio back on track and restore your target asset allocation.

1. Step 1: Find a suitable target asset allocation

Each investor’s risk tolerance and expected return vary. You must first identify what’s optimal for you. If your risk appetite is high, you can allocate more resources to the equity segment, whereas if you don’t want to take much risk, you should opt for a more conservative asset allocation.

2. Step 2: Evaluate your portfolio’s current standing

Classify your portfolio investments into the broad asset classes. Convert the total values of each into a ratio. Once done, evaluate the asset mix against the target asset allocation to understand how you should rebalance your portfolio.

3. Step 3: Identify the assets to redeem or purchase

This step focuses on taking action by buying and selling some assets. Redeem the assets that are beyond the target asset allocation and invest in the ones that are below the desired levels. Suppose you desire a 70% stocks and 30% bonds asset allocation, but the current split is 90% stocks and 10% bonds. The new allocation exposes you to more risk than you can tolerate. So, you need to redeem stocks and invest in bonds.

4. Step 4: Assess the impact on taxes

The changes you make to your portfolio will result in either tax benefits or liabilities. Understand these obligations and the tax regulations to pay the dues on time and take advantage of the benefits without any hassles.

5. Step 5: Track your portfolio regularly

After completing this round of portfolio rebalancing, you can track your investments based on various market movements. When the time for a periodic review arises, you can restart from step 1 and rebalance your portfolio as per the requirements. The interval to rebalance your portfolio depends on your investment preferences. You can do it monthly, quarterly, semi-annually, or annually, or when an asset’s performance exceeds your target asset allocation levels.

Rebalanced vs. non-rebalanced portfolio

Here’s a comparison of a rebalanced vs. a non-rebalanced portfolio:

Conclusion

Rebalancing might seem counterintuitive at first, as it involves selling well-performing assets and buying underperforming ones. However, during market shifts, rebalancing can help restore balance, control risk, and boost long-term performance. It ensures your portfolio remains in line with your investment goals despite market changes.

Think of it as a disciplined strategy, much like investing via SIPs. Rebalancing primarily serves as a risk management tool, reducing volatility and improving risk-adjusted returns over time. By making periodic adjustments, you can maintain the desired asset allocation and improve your portfolio’s overall stability and growth potential.Are you still at the stage of balancing your portfolio but need help? Building an investment portfolio that perfectly suits your investment goals, risk appetite, and other key requirements can now be done using Tata Capital Moneyfy's mutual fund investment app. Compare different fund options from the comfort of your home and invest in the ones that align with your goals.