Portfolio Rebalancing: Meaning, Importance

Date: 14th October 2024 | Read time: 3 Minutes

Portfolio rebalancing is actually one of the fundamental strategies for maintaining your desired investment goals and risk tolerance in mutual funds. Indeed, as market conditions vary, the asset allocation in your portfolio would shift accordingly, and you could end up with an imbalance in the amount of risk and returns you had initially sought. Therefore, understanding what portfolio rebalancing means is crucial to maintaining investor loyalty to attaining financial objectives.

In simple terms, portfolio rebalancing is a process that brings various different assets in your portfolio back to your target allocation by adjusting the weight. As time passes, the performance level of different assets such as stocks, bonds, or others could be different due to which the balance of the portfolio goes away; rebalancing ensures that the original balance is restored once again.

But assuming you desired to have 60% equities and 40% bonds in your portfolio, for example, but the equity market performed quite well in the period covered, then this would have to change to 70% equities and 30% bonds. You will then be required to sell out parts of the equities you have or invest more in the bond investment, so that to return your portfolio to the 60:40 ratio.

Portfolio rebalancing is necessary for the following reasons.

1. Risk Management

   The market may, paradoxically, increase the risk within your portfolio with its fluctuations. You may rebalance to regain the level of risk you have desired by readjusting your mix of assets.

2. Reaching Financial Objectives

   Mostly, in most cases, whenever you are seeking to achieve financial objectives, your investment-allocation pattern would appropriately take care of those objectives. Portfolio rebalancing ensures that your investments are brought back on course.

3. Market Timing Avoidance

   That rebalancing is not a step in predicting when the market may or will move but rather a responsible behaviour that subdues making emotional decisions and leads to stability within the long run.

Suppose an investor had an initial investment mix of 70% in equity mutual funds and 30% in debt mutual funds. Over time, because of the surge in equity markets, the investment mix shifts to 80% in equity and 20% in debt. To rebalance the initial investment mix, he sells a portion of the equity holding and uses the proceeds to invest in debt mutual funds. This example is that of rebalancing to maintain the desired asset mix.

There are a few approaches to rebalancing:

• Periodic Rebalancing

  This involves rebalancing your portfolio at fixed intervals (e.g., annually or semi-annually).

• Threshold-Based Rebalancing

  In this method, you rebalance your portfolio when the asset allocation drifts beyond a specified threshold, such as 5% or 10%.

[Also Read: Taxes On Mutual Funds]

To rebalance your portfolio, follow these steps:

1. Review Your Current Allocation

   Compare the current asset mix with your target allocation.

2. Sell Overperforming Assets

   Sell the assets that have exceeded your target allocation.

3. Invest in Underperforming Assets

   Use the proceeds from the sale to invest in assets that are underperforming to restore balance.

Portfolio rebalancing is an important process as it will help ensure that the mutual funds invested in are aligned with your financial goals and your overall risk tolerance. Understanding the importance of rebalancing and being disciplined in approach can make the management of this process much better and bring your investment plans on track.