Portfolio rebalancing can be defined as adjusting the weight of different assets in your investment portfolio. It involves periodically purchasing or selling securities in the portfolio to maintain its original or desired asset allocation level. Usually, the changing market conditions warrant a change in the asset mix. Besides, a change in your financial status, goals, risk-return profile, and investment strategy requires portfolio rebalancing as well.
Benefits of rebalancing
- Risk minimisation
One of the primary benefits of rebalancing is risk minimisation. Sometimes, you may allocate a larger proportion of your wealth to a particular security or asset class due to its superior performance. However, dynamic market conditions may lead to a dip in the return-generation potential of the overexposed asset. Under such circumstances, portfolio rebalancing helps you offset losses from one asset through gains from another.
- Tax-savings
Increasing the proportion of tax-saving instruments like Equity-Linked Savings Scheme (ELSS) funds in your portfolio reduces your tax liability. Moreover, you may sell off your stock/fund units as a tax-loss harvesting mechanism to lower your capital gains and, subsequently, your taxes.
- Capital appreciation
When your capital grows, wealth is created. If your portfolio is not growing at the desired risk-adjusted rate, it’s time for portfolio rebalancing. For instance, you may sell off low-performing assets or transfer investments from fixed-income instruments to equities to achieve the intended growth rate.
How to rebalance a mutual fund portfolio?
Some of the commonly used portfolio rebalancing strategies are as follows:
- Rebalancing using original allocation ratios
Suppose your initial fund allocation ratio was 70:20:10 between equity, debt, and money market instruments, respectively. You can accept a fluctuation in asset weightage up to +/-4%. Now, suppose market vagaries have modified your portfolio asset mix to 75:20:5. You will sell off 5% of equities to buy 5% of money market assets and restore original asset allocation weightings.
- Rebalancing based on the market trends
It is a dynamic portfolio rebalancing strategy wherein emerging market trends dictate changes in your portfolio weightings. For example, geopolitical conditions may lead to a fluctuation in the prices of precious metals. You may sell off your gold or gold Exchange Traded Funds (ETFs) in a falling market scenario and invest the proceeds in other investment avenues.
- Rebalancing based on the fund manager’s discretion
The success of this portfolio reallocation strategy solely depends on the ability of the fund manager to anticipate future market outlooks. Since the outcome of this strategy is contingent on the fund manager’s subjective investment approach and market research, it is one of the aggressive portfolio rebalancing strategies.
- Rebalancing using a thumb rule
You can have some pre-set rules like if the Price-to-Earnings ratio (P/E) equals or exceeds 20, you will decrease your equity holdings by 6% and vice-versa. In short, based on certain pre-specified limits or rules, you can rebalance your portfolio.
Final words
Portfolio rebalancing is a periodic process. Certain investments like the dynamic asset allocation or balanced advantage mutual fund schemes materially modify their asset mix based on changing market conditions. You can consult a financial advisor who can help you pick suitable funds for your investment goals and provide expert guidance on portfolio rebalancing.
