What is Portfolio Rebalancing and how to do it?

Created on 27 Aug 2021

Wraps up in 5 Min

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Updated on 06 Aug 2022

There is this famous saying that we’re sure you’ve heard, “Don’t put all your eggs in one basket”. This phrase clearly states that one must diversify his funds and construct a portfolio that is the most feasible to him.

But is that all? Is mere construction of a portfolio sufficient for good returns? This is what we will uncover today. Continue reading to understand how the efficiency of a portfolio can be maintained consistently.

Meaning of Portfolio Rebalancing

Portfolio rebalancing simply refers to the process of altering the proportion of various assets in one's portfolio. It is an extension of the asset allocation process. In asset allocation, one decides upon a portfolio that would provide an investor with the maximum returns at a minimum level of risk, of course considering other factors. However, this portfolio must be reassessed at regular intervals to check its efficiency, which, in the market parlance, is known as Portfolio Rebalancing. 

Is rebalancing your portfolio crucial?

Short answer - Yes.

Long answer - Rebalancing a portfolio is an essential element. Firstly, it helps assess and minimize the overall risk of one's portfolio. The various classes of assets held will not yield the same returns over a period. The variation in the returns will lead to a change in the proportion of these assets. If the proportion of a risky asset rises, rebalancing will help recognize this and bring it back to its initial classification.

Secondly, it ensures that the portfolio is in alignment with the financial goals of the investor. Usually, a long-term investor's risk appetite may change over a period. The expectations of returns might also fluctuate. For instance, a young individual's risk appetite grows as he begins to earn higher income from his primary source. He would prefer to increase the proportion of equity and reduce the debt component. To enable this, he could rebalance his portfolio.

Thirdly, it helps the investor to sell high and buy low. If one does not keep a regular check on how the assets in his portfolio are performing, he might lose the chance to earn an extra bit. A constant review would help him buy and sell at the right time to make profits.

When should you rebalance your portfolio?

Now you might wonder at what intervals must one rebalance his portfolio. Well, honestly, there isn’t a “one-size-fits-all” answer to this. The intervals at which one must rebalance the portfolio depend on several factors like the nature of the asset classes held, time constraints, tax considerations, and the transaction costs incurred. In general parlance, rebalancing done once a year works just fine.

However, if your portfolio is dominated by equity, you might want to rebalance it at time intervals even less than a year. Having said that, too frequent rebalancing might be disadvantageous as it would incur costs higher than the gains earned. 

(Source: Pension mark)

How to rebalance your portfolio?

As mentioned earlier, there isn’t one specific strategy that works for every investor or every portfolio. There are multiple strategies devised to help one rebalance his portfolio.

The simplest way to go about rebalancing your portfolio is by first recording the proportion of the assets classes held, their current values, and the cost incurred. After a stipulated period, go back to compare the current figures to the historical ones. If necessary, make appropriate changes.

There are other strategies that you can use as a blueprint to begin your rebalancing process. Let’s look into a few of those:

  • Calendar Rebalancing

As the name suggests, it involves altering the portfolio at specified intervals. It could be monthly, quarterly, half-yearly, annually, or even longer. For instance, if you prefer to perform the process monthly, you can decide on a date and revisit your portfolio on that particular date every month. This is the most hassle-free method. However, this method is suitable for portfolios dominated by fixed interest securities as their values do not fluctuate as much.

  • Constant Mix Strategy

Under this, every asset class or individual security is allotted a percentage of deviation. This usually is 5% or 10%. Once the target is crossed, the portfolio requires rebalancing. This method is most preferred when the proportion of equity in a portfolio is higher than other asset classes. It is a more efficient method when compared to calendar rebalancing. Constant mix strategy helps retain the initial asset allocation that was decided upon, thereby balancing the overall risk and return of the portfolio.

  • Introduction of fresh funds

Until now, we understood that existing funds could be altered to rebalance. However, an investor can park additional funds strategically into a portfolio to rebalance it. For instance, if the weight or proportion of one asset is increasing, funds can be invested in the other assets to maintain balance. This method, in a way, promotes discipline and also helps the investor to improve his portfolio gradually, both qualitatively and quantitatively.

  • Rebalancing based on tax implications

We definitely cannot miss this method as tax is one of the primary factors that Indians consider during their financial planning. The securities and the returns earned are exposed to tax liabilities. With the dynamic tax regulations, one might want to rebalance his portfolio to ensure that the tax does not consume his profits.

Wrapping up...

Personal financial management is definitely a difficult nut to crack. With the impending need to increase sources of income to move ahead of the rising inflation and the availability of a wide range of investment products, one can get lost in the vicious cycle of not knowing where to start and how to proceed.

That’s where platforms like Recipe by Finology come in handy. It understands and analyzes your financial position, risk appetite and dream goals, and then suggests you an appropriate asset allocation based on all those factors. That way, you have a launchpad to start with.

Moreover, if you have a salary increment or change in expenses or a new dream goal, you can just update it, and Recipe will tell you what your rebalanced asset allocation should ideally be. Not only that, if in case you aren’t on track to achieve any of your goals or lack a sound financial plan, it will suggest to you an appropriate tweak that will fix the leakages in your financial plan and help you accomplish your goal. As people say, “It’s clever” ...isn’t it?

So, what are you waiting for? Get a scientifically designed financial plan made for you by experts! Sign up to Recipe by Finology.

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Deb P Samaddar

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If people could be named after idioms, Deb would be called "I'm all ears." His brain is a storehouse, ever overflowing with derelict information. So, while most things he talks about are as useless as occasion-less greeting cards, everything he writes has the potential of bagging you multiple diplomas!

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