When you first constructed your financial portfolio, you probably looked at various things such as your financial goals, age and risk tolerance. The intention was to come up with the most suitable asset mixture for you; this could have been a specified equity-to-bond ratio.
However, since financial markets are dynamic, the initial allocation may change as some investments perform better than others over time. Portfolio rebalancing refers to the periodic evaluation and modification of an individual’s investment basket to keep it at the required risk level for long-term financial gain.
This article examines what portfolio rebalancing means, why it matters, and when this process should be done.
What is Portfolio Rebalancing?
Portfolio rebalancing refers to the process of adjusting the proportions of assets or removing or purchasing some stocks/assets in your investment portfolio back to their predetermined levels, i.e. as per your investment goal.
For instance, let’s say that your initial allocation is targeted at 50% stocks, 30% bonds, and 20% real estate. But, further on, if equities outperform and represent 60% of the total value while bonds decrease up to 20%, with no change in the real estate holdings, then rebalancing will include trimming stocks and purchasing more bonds to restore the original goal. This is done so that one’s portfolio can have the desired level of risk as well as the expected potential return.
Periodic portfolio rebalancing may be required because each asset class’s market value changes over time due to the various potential returns they earn. Hence, this can make your choice deviate from what was initially targeted or wished for, thus making it subject to more or less risk than intended. Therefore, you will need to periodically rebalance your investment account to facilitate this reallocation.
Moreover, if you have altered your investment portfolio or even have changed risk tolerance levels, then you may consider using this method so that you can change weights on all securities in a given security basket as per your investment goal.
Advantages and disadvantages:
| Advantages | Disadvantages |
| Balances Gains and Uncertainties: Helps align potential returns with market fluctuations. | Potential Decreased Efficiency: Frequent changes might reduce overall performance. |
| Maintains Financial Goals: Seeks to Ensure your investments stay on track with your objectives. | Increased Risk Exposure: Incorrect decisions can heighten risk. |
| Achieves Desired Outcomes: Regular adjustments help to meet your financial targets in the long run. | Higher Transaction Costs: Rebalancing frequently may result in higher expenses. |
| Reduces Risks: Aim to minimise exposure to unwanted risks. | Requires Expertise: Effective rebalancing demands significant knowledge and understanding. |
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Why is Portfolio Rebalancing Important?
Rebalancing the portfolio makes it possible for you to execute whatever adjustments you may make in your asset allocation plan and remain on course. Here are some benefits of rebalancing a portfolio:
- Maintains the Initial Asset Mix: Notice how your portfolio’s asset mix has changed over time. Consequently, the risks of investments and expected potential returns may no longer suit you. Rebalancing can help correct this.
- Improved Risk Management: The risks associated with an asset might change over time. Hence, it could be necessary to re-evaluate your portfolio’s riskiness and alter the mix of assets accordingly. Nevertheless, through methodical rebalancing of portfolios, it may be considered possible to regulate how much trouble you undertake.
Portfolio Rebalancing Example: For example, imagine an investor with a 60/40 portfolio, where 60% is in equities and 40% is in bonds. In a stable economic environment with moderate growth and stable inflation, the investor might expect equities to return 12% and bonds to 6%. By periodically rebalancing the portfolio to maintain the 60/40 split, the investor aims to achieve a balanced risk-return profile, potentially yielding an average annual return of around 10% with reduced volatility.
- Helpful in New Investment Plan Adjustments: Gradually growing older often comes with new insights. Also, most investors become more prudent as they age. You can always seek to revise and adjust your investment style and strategy if you systematically rebalance your portfolio.
- Selling High & Buying Low: Through rebalancing, investors are naturally induced to sell higher potentially returning assets and buy more of those that have lower potential returns. Although it may seem paradoxical, recalibration can be an effective long-term tactic for managing market-related risks.
Let’s use an example to illustrate how rebalancing can enhance long-term potential returns by seeking to sell high-performing assets and buying lower-performing ones.
For example, an individual wants to invest ₹20,000 in the ratio of 50:50 in the Nifty 50 TRI index and the Indian Government Bonds. The following table will demonstrate how the ratio changes over time without rebalancing the portfolio, exposing the investor to unforeseen risks.
| Year | Equities (Nifty 50 TR index) | Bond (Government Bond) | Portfolio Ratio (Without Rebalancing) | Portfolio Ratio (With Rebalancing) | ||
| Rates | Amount | Rates | Amount | 50:50 | 50:50 | |
| 2015 | -3.0 | 9,700.00 | 0.43 | 10,043.00 | 49:51 | 50:50 |
| 2016 | 4.4 | 10,126.80 | 0.27 | 10,070.12 | 50:50 | 50:50 |
| 2017 | 30.3 | 13,195.22 | -1.61 | 9,907.99 | 57:43 | 50:50 |
| 2018 | 4.6 | 13,802.20 | 1.42 | 10,048.68 | 58:42 | 50:50 |
| 2019 | 13.5 | 15,665.50 | 1.53 | 10,202.43 | 61:39 | 50:50 |
| 2020 | 16.1 | 18,187.64 | 0.69 | 10,272.82 | 64:36 | 50:50 |
| 2021 | 25.6 | 22,843.68 | 0.93 | 10,368.36 | 69:31 | 50:50 |
| 2022 | 5.7 | 24,145.77 | 3.56 | 10,737.47 | 69:31 | 50:50 |
| 2023 | 11.4 | 26,898.39 | 0.22 | 10,761.10 | 71:29 | 50:50 |
(The above figures are for illustration purposes only)
The example illustrates how a portfolio that initially targeted an equal split of equities and government bonds (50:50) could go significantly off course over time if not adjusted periodically to compensate for different investment performances.
When Should You Rebalance Your Portfolio?
Portfolio rebalancing may be triggered by investors in three significant ways:
- Time-Based Trigger: It is a schedule that specifies the time for rebalancing, such as monthly, quarterly or yearly.
- Threshold-Based Trigger: Under this method, if the asset allocation of the portfolio goes off target by a certain percentage, then rebalancing is triggered.
- Combination Trigger: This approach combines both time-based and threshold triggers with an interval setting or a predetermined percentage of deviation in asset allocation to cause portfolio rebalancing.
You can decide to do a portfolio rebalance after one month, three months, six months or even every year. It depends on you. Nonetheless, remember that waiting for a long time to rebalance your portfolio can lead you to miss the opportunity to take advantage of the dynamics of the market.
For e.g., from its peak of ₹12,430.50 in January 2020 to its lowest point of ₹7,511.10 in March 2020, the Nifty fell by almost 38%. After hitting its lowest point, the Nifty increased 86%, ending 2020 with a 15% gain.
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How to Rebalance Your Portfolio?
Let’s break down portfolio rebalancing into simpler steps:
- Set Your Asset Allocation: You should decide the proportions and amounts of your investments that you want to invest in various types of assets, such as equities, fixed-income securities, and others, based on goals for investment, time horizon, and risk appetite.
- Review Your Current Allocation: If you find a mismatch between what you have invested so far and your desired investments, then it is time to make some changes.
- Buy or Sell Assets: Buy only underweight assets and sell those that are overweight to align these with the target allocations.
- Consider Tax Implications: Be tax-conscious while dis-investing. Start by selling those which attract tax benefits.
- Monitor Regularly: Keep track of how well your portfolio is doing and check it periodically (on a quarterly, semi-annual or annual basis). Rebalance again if needed due to market changes or shifts in your goals.
Case Study:
Suppose you want to rebalance your portfolio; let’s check how to do it.
| Step | Action | Details |
| Set Your Asset Allocation | Decide proportions for investments | Total Allocation: – 60% in equity instruments(equity funds) – 30% in debt instruments (debt funds) – 10% in alternative investments (real estate, gold, etc.) Equity Allocation: – 70% large-cap funds – 20% mid-cap funds – 10% small-cap funds |
| Review Current Allocation | Compare current allocation with target allocation | Current Total Allocation: – 70% in equity instruments (equity funds) – 20% in debt instruments (debt funds) – 10% in alternative investments Current Equity Allocation: – 60% large-cap funds – 25% mid-cap funds- 15% small-cap funds |
| Buy or Sell Assets | Adjust investments to match target allocation | Actions Needed: – Sell 10% equity – Buy 10% more in debt funds Equity Adjustments: – Sell 10% of mid-cap and small-cap funds – Buy 10% more in large-cap funds |
| Consider Tax Implications | Assess tax impact when selling investments | Capital Gains Tax: – Taxable Gains- Tax to be Paid |
| Monitor Regularly | Continuously review portfolio performance and adjust as needed | Review Frequency: – Quarterly, semi-annually, or annually – Rebalance based on market changes or shifts in financial goals |
(The above scenario is for educational purposes only, and investors should consult their financial advisor before investing)
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To Sum Up
Any investor who wants to seek long-term financial investment and aims for growth, in the long run, should make it a practice to readjust the contents of their portfolio.
Once you understand why it is important, and adopt a systematic way of handling it, then you may be able to wade through the ups and downs in the market, minimise risks as well and aim that your investments align well with your future money targets.
For both beginners and seasoned investors alike, regular adjustments are what keep a robust, diversified portfolio in place for many years.
Frequently Asked Questions
Is portfolio rebalancing a good idea?
Portfolio rebalancing is important for maintaining your chosen asset allocation, managing risks and optimising potential returns. It seeks that your investments are in line with your financial objectives as well as your risk appetite, reducing exposure to particular asset classes and promoting long-term stability.
What is the 5% portfolio rule?
While diversification lessens the risk of any single investment affecting the whole portfolio adversely, this can be achieved by investing not more than 5% of total investment in one stock. This reduces the amount of exposure that you could have had in a case where one investment went wrong. However, we suggest that the said rule is for illustration purposes only, and an investor should consult their financial advisor before investing
Does rebalancing increase returns?
Rebalancing itself does not guarantee potential returns but helps with managing risks and keeping to an asset allocation plan, which we feel most comfortable with, i.e., one that comes close to our investment objective. Rebalancing improves long-term performance because it involves systematic investing that follows market trends through selling high-performing assets and buying undervalued ones.
Does portfolio rebalancing reduce risk?
Yes, portfolio rebalancing reduces risk by maintaining your desired asset allocation, preventing overexposure to any single asset class. It ensures that your portfolio stays aligned with your risk tolerance and investment goals, especially after market fluctuations, thereby optimising the risk-return balance and enhancing long-term financial stability.