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What is Portfolio Rebalancing and Why is it important for Investors?

By Vasu Bandaru, Director, The Componding Advantage

Vasu Bandaru
Vasu Bandaru

When it comes to wealth creation, one of the paramount factors in this journey is adhering to asset allocation. Depending on factors such as age, financial goal, risk profile and the number of years one can stay invested, an advisor puts together a portfolio in which an investor has exposure to various asset classes. Each asset class is given a certain allocation. For example: The exposure to equities could be 50%, debt 30% and gold 20%.  

However, this allocation percentage is not stagnant in nature. In case if there was a rally in equities, the allocation can move to 60%. This means the portfolio exposure to equities is more than the desired level and hence rebalancing becomes necessary. So, what exactly is rebalancing? 

Rebalancing is the process by which an investor restores his/her portfolio to its target allocation. In effect, rebalancing brings your portfolio back to the desired asset mix. In this case, the equity allocation will be trimmed by 10% to bring it back to 50% allocation.  

Why is Rebalancing important? 

The primary objective of portfolio rebalancing is to establish better risk control. Hence, this activity from an investor perspective is largely a risk-minimizing strategy. Rebalancing ensures that your portfolio is not singularly dependent on the success or failure of any one particular investment, asset class, or fund type. Also, it keeps the portfolio aligned with your goals at all times. Over the years if your risk tolerance or your investment strategies change, then you can rebalance the weight of the asset class in your portfolio by reassessing and devising a new asset allocation. 

How can you rebalance your portfolio? 

When you invest across several mutual funds, the idea scenario is that each investment should be tagged to a particular financial objective. This will ensure that you remain dedicated and on track to achieve that particular financial goal. So, when initiating a portfolio rebalance activity because of the change in risk profile, remember to make the changes across asset classes in one-go.  

Here’s how you can rebalance your portfolio in 5 simple steps:  

Step 1: Have an asset allocation plan/framework drawn post considering your income, expected time of retirement, risk appetite etc. In case you are unsure how to go about it, seek the help of a financial advisor. Spend as much time required to get all the facts and figures, such that the plan prepared can be robust in nature.  

Step 2: Assess your current asset allocation by identifying where and how your current investments are placed in stocks, cash, bonds, or any other form of investment. After this, make a comparative analysis of asset allocation targeted and its present state. Take corrective actions accordingly. 

Step 3: Chart out a rebalancing plan if your asset allocation target does not align with your current portfolio. This step can be tricky where you have to decide on the securities to retain and in what quantity. Here, an advisor will be very helpful.  

Step 4: Be mindful of tax implications, especially in terms of capital gains. Try and avoid short term taxes on capital gains by holding on to your equities for over a year. In the case of debt funds, short-term capital gains will qualify for taxes based on an individuals’ income tax slab. For long-term capital gains, the tax is 20% with indexation. If you need to scale back, aim to sell the securities in the tax-exempt accounts first. In this way, you can limit the taxes you pay in capital gains.  

Step 5: Review your portfolio at least once a year to assess your position but rebalance it only when the allocation is significantly out of the track in terms of reaching the target set. 

To conclude, rebalancing of a portfolio is more about identifying and implementing a system that works best for you as an investor. It must never be about merely adopting what works well for someone else. At the same time, it also entails reviewing and making informed adjustments, keeping in mind the tax and other consequences.