What is Portfolio Rebalancing? And Why is it important?

For the investing world, the term ‘Portfolio’ means a basket of securities. There is a popular saying that- ‘Do not put all your eggs in a single basket’. A similar strategy is applicable for your investments too. While investing in the financial market, it is always recommended to spread your investments across diversified securities to reduce risk. And this collection of diversified financial instruments is termed as a portfolio.

While creating a portfolio one should always aim to build a balanced one. A balanced portfolio can reduce portfolio risk and also offers stability. Let us understand it better with the help of an example.

Suppose Arjun, a 25-year-old salaried guy, has a current net worth of Rs 5 lakhs. Out of his entire worth, he has invested Rs 4.5 lakhs is stocks and has kept the remaining money as cash in hand. Here, although Arjun’s portfolio consists of two different assets (i.e. cash in hand and stocks), however, do you think his portfolio can be called balanced?

What, if the market witnesses a bearish trend for the next two years? In such a scenario, Arjun’s portfolio might look almost all reddened as he has invested 90% of his entire net worth in the stock market.

However, let’s consider another scenario where Arjun has diversified his assets smartly in different securities and his portfolio looks something like this:

— Investment in stocks = Rs 2 lakh
— Investment in debt funds = Rs 2 lakh
— Cash in hand = Rs. 1 lakh

The above portfolio looks a little balanced as Arjun has allocated his investments better this time. In this case, even if the stock market fails to perform well for quite some time, the loss on stocks (if any) will be mostly absorbed by the returns from the debt funds. Therefore, despite the things do not work out as well as planned, Arjun will either lose only a minor portion of his corpus or won’t lose anything at all.

Overall, a balanced portfolio helps the individuals to spread their investments across high-risk instruments to low-risk securities. In the simple example discussed earlier, Arjun has constructed a balanced portfolio by investing smartly in stocks (high-risk securities), debt funds (low-risk instruments) and cash in hand (lowest risk of all).

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What is portfolio rebalancing?

So far we have just talked about portfolio balancing or a balanced portfolio.

However, as assets appreciate/depreciate with time, this allocation may change in the future and even a balanced portfolio may not remain balanced over time. In Arjun’s case, suppose his portfolio looks like this after 5 years since he originally invested:

— Stocks = Rs. 3.8 lakhs
— Debt funds = Rs. 2.2 lakh
— Cash in hand = Rs. 1 lakh

Here you can notice that Arjun’s assets have gone up by Rs. 2,00,000 in 5 years. This majorly happened because his investments in stocks have performed well and given him amazing returns.

However, his current portfolio is different from his original desired asset allocation. Initially, his portfolio consisted of 40% in stocks, 40% in bonds and the rest 20% in cash. However, his current allocation consists of 54.28% in stocks, 31.4% in bonds and remaining in cash. Obviously, if Arjun wants to restore his original allocation, he will have to sell a few of his stocks and increase the investments in bonds so that both get adjusted back to 40% each. This activity is called portfolio rebalancing.

Portfolio rebalancing involves periodically buying and selling assets for the purpose of keeping the portfolio aligned to the predetermined strategy or risk level. In other words, during portfolio rebalancing, you’re selling off those securities which you do not require anymore and reinvesting the proceeds to buy the instruments you need. Another key point to note here is that in portfolio rebalancing, you are not adding any fresh money to your existing portfolio. You are simply adjusting the allocation in your portfolio.

Why does your portfolio need rebalancing?

Here are a few of the biggest reasons why you need to rebalance your portfolio at regular intervals.

1. If you don’t rebalance your portfolio periodically, it may get riskier with time.

You should rebalance your portfolio at regular intervals to maintain the desired risk level, especially in case of big changes in the market. Furthermore, it is a known fact that as you grow older, your risk appetite decreases. Therefore, in that case, you should develop a habit of constantly shifting your assets from equity to debts to add stability to your portfolio against the risk of loss.

2. It helps is keeping your portfolio in line with your goals/needs

Along with maintaining your existing corpus, improving returns is also necessary to grow your wealth. Equities or Equity based Mutual Funds are mostly used for beating the benchmark indices and earning sufficient inflation-adjusted returns. However, if you find any of your stocks are constantly underperforming for a considerable amount of time, you should consider replacing them with some other securities. A disciplined portfolio rebalancing will ensure that your portfolio is aligned with your financial plan.

3. Portfolio rebalancing helps in planning your taxes.

Equities and Equity based Mutual Funds attract 10% long term capital gains tax if such capital gain exceeds Rs.1 lakh.

If you a small investor, you can consider redeeming your equities in a financial year and invest the proceeds elsewhere. This will not only help in booking profits but will also help you in spreading your tax liability uniformly across the years. Similarly, you can also plan to redeem your investments in such a way that you can carry-forward your previously-occurred capital gain losses or to set off against capital gains to save further taxes in future.

Incurred Costs while rebalancing your portfolio

Portfolio rebalancing is not free as it costs money for buying and selling the assets. Here are a few common costs that you have to incur for rebalancing your portfolio:

1. Whenever you buy or sell any financial instrument, you have to incur a few unavoidable expenses in the form of brokerage, STT, commission, stamp duty etc. Although you can reduce the incurred costs by using discount brokers or investing in direct mutual funds, however, you cannot avoid them completely.

2. You may have to pay some unnecessary taxes: When you rebalance your portfolio, you get involved in selling a few of your investments. This might result in capital gains which attract tax liability on the same. Further, if you rebalance your portfolio too fast and sell your assets, you have to pay Short-term capital gain taxes (which is almost always higher than the long-term capital gain taxes).

3. You may have to pay some penal charges: If you redeem a few investments before a specified time period (or locking period), you may have to pay some penal charges. For example, if you withdraw your money from your ongoing Fixed Deposit Account, your Banker may impose a nominal penalty. Similarly, if you redeem your Equity Mutual Fund units within a year, you may have to pay an exit load.

Closing thoughts

If you want to get into physical shape, the balanced diet is a must. Similarly, if you are willing to generate long term wealth through your investments, creating a balanced portfolio is essential. However, your portfolio will remain balanced for long-term only if you keep rebalancing the same at adequate intervals of time.

To be honest, no one can tell what must be the exact time to rebalance your portfolio. Nevertheless, it is recommended that you should keep checking the allocation of your assets in your portfolio at least every year or two. This will ensure that your investments are in line with your goals/needs.

That’s all for this post. I hope it was useful for you. Happy Investing!