Portfolio Rebalancing means buying and selling parts of your investments to keep the original mix. As market values change, you might need to do this regularly. If you haven’t done it recently, talk to your financial advisor. Checking your portfolio every few months or once a year is wise. This check-up might not need action but ensures you stay on track.
Investing in the markets is not a one-time exercise. Purchasing the assets for your portfolio is only the first step. After this, there are various other essential aspects like portfolio review, portfolio rebalancing and market tracking. While many investors watch the markets and their portfolios diligently, only a few are aware of the meaning of portfolio rebalancing, its importance and how to carry out this technique effectively.
If you too have been having trouble grasping and implementing this essential concept, this article can help you understand what portfolio rebalancing is and how you can do it to obtain the best results.
What is portfolio rebalancing?
Portfolio rebalancing refers to the process of adjusting the weightings of different assets within an investment portfolio. This practice involves redeeming specific investments and reallocating funds to other assets in order to restore the desired target asset allocation. The goal of portfolio rebalancing is to ensure that the asset mix aligns with the proportions you initially set, taking into account your risk tolerance and expected returns. Understanding portfolio rebalancing meaning is essential for maintaining a balanced and effective investment strategy.
The process of portfolio rebalancing is necessary because over time, as the markets change, the value of different assets in your portfolio will also increase or decrease accordingly. This changes your original asset mix, leading to a possibly less-than-favourable asset allocation. To restore the proportion to the ideal levels, you need to rebalance your portfolio.
How does portfolio rebalancing work?
Portfolio rebalancing involves adjusting the proportion or weightage of different assets in a portfolio to bring it back to your preferred asset allocation. Let us discuss an example to understand portfolio rebalancing better.
For instance, say you create an investment portfolio with an asset mix of 60% in equity and 40% in debt. By the end of the first year, your equity investments perform exceptionally well and therefore, increase in value. This results in the new asset mix of 80% in equity and 20% in debt.
The rise in the value of equity investments increases the overall risk in your portfolio. By carrying our portfolio rebalancing immediately, you can restore the asset mix to the original 60:40 ratio for equities and debt respectively.
Read also: What is portfolio diversification?
How to rebalance your portfolio?
Portfolio rebalancing is a crucial investment strategy that involves adjusting the weightings of assets in your investment portfolio to maintain your desired risk-return profile. So, what is portfolio rebalancing? It is the practice of periodically reviewing your current asset allocation and comparing it to your original target allocation. This process ensures that your investment portfolio remains aligned with your financial goals and risk tolerance.
To effectively rebalance your portfolio, start by assessing your current asset allocation. For instance, suppose your ideal target allocation is 70% in equities and 30% in debt instruments. If you initially invest Rs. 7 lakh in equity stocks and mutual funds and Rs. 3 lakh in debt funds, your portfolio is well-structured. However, as the market fluctuates, the value of your investments may change.
At the end of the financial year, you might discover that your equity investments have appreciated significantly, increasing to Rs. 12 lakh, while your debt investments have grown to Rs. 4 lakh. This change results in a new asset allocation of 75% equity and 25% debt, which deviates from your preferred ratio of 70:30.
To restore your original allocation, you need to calculate the adjustments required. In this case, you should redeem a portion of your equity holdings. Specifically, you would sell off 5% of your equity investments to bring your portfolio back to the desired 70% equity and 30% debt allocation. The proceeds from this sale can then be reinvested in debt instruments to achieve your targeted balance.
By engaging in portfolio rebalancing, you ensure that your investment strategy remains consistent with your financial objectives and market conditions. This disciplined approach not only helps mitigate risks but also enhances the potential for long-term returns. Regularly reviewing and rebalancing your portfolio can significantly contribute to effective wealth management, allowing you to navigate the dynamic investment landscape with confidence.
Why portfolio rebalancing is important
Portfolio rebalancing is an important aspect of financial planning and investment strategy because of the following reasons:
- Asset allocation maintenance
It helps you retain the original asset allocation that you require to achieve your goals without compromising on your risk tolerance levels. You can use portfolio rebalancing to ensure that your asset mix remains aligned with your risk-reward preferences. - Improved risk management
With portfolio rebalancing techniques, you can also manage risk better. By checking the asset allocation and making changes as needed, you can ensure that you do not increase the risk to a degree beyond the level you are comfortable with. - Effective new investment strategies
Portfolio rebalancing is not just about maintaining the desired asset allocation. It also helps you implement new investment strategies to keep pace with your evolving goals and changing risk tolerance levels. As your risk-reward preferences transform, you can rebalance your portfolio accordingly. - Buying low and selling high
When you use portfolio rebalancing to restore the original asset allocation, you invariably sell high and buy low. This is because you redeem the assets whose values have exceeded the desired allocation — meaning that you sell them high. These proceeds then go to buying other assets that have reduced in value.
A step-by-step guide to portfolio rebalancing
If you are a beginner to investing, portfolio rebalancing may seem like a daunting task. The following stepwise guide can help you get more clarity on how to restore your target allocation to the original levels.
- Identify your optimal asset allocation
Depending on your risk tolerance and your expected returns, you need to figure out the asset allocation that is ideal for you. If you are a risk-taker, you may want to allocate more resources to the equity segment. Alternatively, if you prefer to avoid risk, you may require a more conservative asset allocation. - Check your portfolio’s current asset mix
Review your portfolio and assess its current asset allocation. To do this, you simply need to identify the different broad asset classes in your portfolio, note each of their total values and convert them into a ratio. Compare this asset mix with your desired asset allocation to understand how to carry out your portfolio rebalancing. - Identify which assets to purchase or redeem
This is the practical part of portfolio rebalancing, where you need to buy some new assets and sell others. You need to redeem the assets that have exceeded their original asset allocation and invest further in those that have fallen below the preferred target levels. When you do this, you may incur some costs to redeem or buy new assets. - Review the impact on your taxes
When you sell certain assets and securities like stocks or mutual funds, you may incur tax liabilities or earn tax benefits. It is essential to be mindful of these tax regulations so you can pay the taxes due on time and also take advantage of any tax benefits that arise promptly in the relevant assessment year. - Monitor your portfolio periodically
Once the round of portfolio rebalancing is complete, you can simply sit back and track your investments as the market moves through different cycles. When it is time for your periodic review, you can once again begin at step 1 and carry out portfolio rebalancing, if needed. You can choose to rebalance your asset mix on a quarterly, semi-annual or annual basis.
Read also: What is a mutual fund portfolio?
Benefits of portfolio rebalancing during volatile markets
Portfolio rebalancing offers significant advantages, especially during volatile market conditions. By regularly adjusting asset allocations, investors can mitigate risks associated with market fluctuations and maintain their desired risk profile. Rebalancing helps prevent overexposure to underperforming assets while ensuring that gains from outperforming investments are effectively reinvested. This disciplined approach enables investors to buy low and sell high, capitalising on market swings.
Additionally, it promotes emotional detachment from investment decisions, reducing the likelihood of panic selling or irrational behavior during turbulent times. Overall, rebalancing serves as a crucial strategy for preserving capital and optimising long-term returns in unpredictable markets.
Advantages and limitations of portfolio rebalancing
Portfolio rebalancing can be beneficial as well as challenging due to various reasons. Let us explore the two sides of this essential investment strategy.
The key advantages of portfolio rebalancing include the following:
- Maintains target asset allocation
- Prevents any single asset from dominating the risk profile
- Helps you align your portfolio with your investment goals
- Allows you to change your portfolio as your goals and risk tolerance levels change
- That said, portfolio allocation also has some limitations, as outlined below:
- Potentially higher transaction and trade costs due to frequent sale and purchase of assets
- May be difficult for beginners
- Could lead to losses if done incorrectly
When to rebalance your portfolio
To ensure that you use portfolio rebalancing to your advantage, you need to time the process right. Ideally, you need to rebalance your portfolio at any of the following points during the investment tenure:
- Based on a timeline: You can choose a specific timeline and frequency to rebalance your portfolio. For instance, you could rebalance it every six months or every year.
- Based on a threshold: If the asset allocation deviates from the preferred ratio by a specific threshold, you could rebalance your assets. For instance, if the asset allocation changes by more than 5%, you may need to change the mix.
- Based on a change in your preferred risk-return ratio: If your risk tolerance changes or if your goals change, you will have to adjust your portfolio to reflect these changes.
Read also: What is the meaning of portfolio composition?
How often is portfolio rebalancing required
The frequency of rebalancing required depends on what you use as a trigger to adjust your portfolio. In the absence of any specific triggers, you can always choose a specific frequency and review your portfolio at regular monthly, quarterly, semi-annual or yearly intervals.
Rebalanced Portfolio vs Non-Rebalanced Portfolio
When managing investments, the approach you take can significantly impact your overall returns and risk exposure. Below is a comparison between a rebalanced portfolio and a non-rebalanced portfolio, illustrating their differences in terms of performance, risk management, and strategic approach.
Aspect |
Rebalanced Portfolio |
Definition |
A portfolio that is periodically adjusted to maintain the target asset allocation. |
Risk management |
Actively manages risk by maintaining the desired asset allocation, reducing overexposure to volatile assets. |
Performance stability |
Offers more stable performance over time, as it aims to align with the investor's risk tolerance and objectives. |
Market reaction |
Responds to market changes by buying low and selling high, thus capitalizing on market volatility. |
Long-term growth |
Facilitates steady long-term growth by ensuring that investments remain aligned with the investor’s goals. |
Emotional discipline |
Encourages a disciplined investment approach, reducing emotional decision-making during market downturns. |
Reinvestment of gains |
Reinvests gains from high-performing assets into underperforming ones, enhancing portfolio diversification. |
Key takeaways
- Portfolio rebalancing is the process of adjusting asset allocations to maintain the desired risk-return profile.
- Regular rebalancing helps mitigate risks associated with market volatility and prevents overexposure to certain asset classes.
- Rebalancing enables investors to buy low and sell high, enhancing potential returns over time.
- It promotes a disciplined investment approach, reducing emotional reactions during market fluctuations.
- Periodically reviewing and rebalancing portfolios ensures alignment with changing financial goals and market conditions.
- Consistent rebalancing contributes to stable long-term growth and effective wealth management.
Conclusion
Portfolio rebalancing is an essential investment strategy for investors across the risk tolerance spectrum. Whether you are an aggressive, moderate or conservative investor, you need to have a specific asset allocation as a benchmark and periodically rebalance your portfolio to maintain the said allocation. This will prevent your portfolio from being overexposed to risks you are not ready to tackle.
If you are a new investor, though, you must understand that various options are at your disposal before making a decision. Begin your investment journey on a trusted platform like the Bajaj Finserv Mutual Fund Platform and pick amongst over a thousand mutual funds to meet your financial needs.
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