Risk management plays an important role in setting up an effective portfolio irrespective of an investor’s style or approach towards investment. Many investors take risk management seriously and proactively realign their portfolios to prevent the significant impact of market fluctuations. This is when portfolio rebalancing comes into the picture as it plays an extremely important role in the investment approach of an investor.
Here, we will explore the concept of portfolio rebalancing and unravel some of the important aspects surrounding it. This will help investors to learn the concept and also implement it in their day-to-day portfolio construct.
What is portfolio rebalancing?
Portfolio Rebalancing involves modification of asset allocation within a portfolio. This is done since each investment’s value can fluctuate because of the constantly changing economy. The central aspect of portfolio rebalancing is asset allocation and how much money does an investor allocate to certain “asset classes” within the portfolio.
In simple terms, portfolio rebalancing uses a weighted average method to determine asset allocation in the portfolio. Rebalancing mainly involves regular purchase or sale of assets to maintain the desired amount of asset allocation within certain risk limits.
Let’s take an example to better understand portfolio rebalancing.
Ritu prefers to have 50% stocks and 50% bonds as an asset allocation in her portfolio. If stocks performed well through the period, the value of the stocks in her portfolio may increase. She can then sell some stocks and invest some of the profits/proceeds in bonds to ensure that the portfolio construct remains as per her 50/50 target in the long run.
When should an investor rebalance a portfolio?
Most investors design their investment strategies for the long-term. However, there can be situations when they need to reconsider the portfolio composition and opt for rebalancing. Here are some of the examples which show that it is the right time to rebalance a portfolio:
- Changes in risk tolerance levels of the investor
- Nearing or the arrival of a financial goal
- An investor nearing retirement
Rebalancing of a portfolio can be done to restore the asset allocation as per changes in investment goals, investment timelines, and risk tolerance levels. While doing so, it is important to remember that changing asset allocation does not always guarantee higher yields or protection against possible future losses.
How does portfolio rebalancing work?
Let’s say the stock market movements of the last three years have resulted in a rise in the value of the stocks that form part of your portfolio. With portfolio rebalancing, the investor can return to the initial allocation if the current level is high as compared with risk tolerance.
How can an investor do this?
In general, there are three key strategies that can be used in portfolio rebalancing. However, neither of these can guarantee returns. It’s important for investors to choose the right approach for rebalancing.
- Periodic rebalancing – Investors can choose a time and ensure to revisit their investments. It is ideal to revisit investments every year. Periodic rebalancing can help in inculcating some amount of discipline and does not take much of an investor’s time. However, with this approach, an investor may miss out on excellent market opportunities to rebalance the portfolio.
- Tolerance band rebalancing – Under this form of rebalancing, an investor aims to align with original asset allocation as per the percentage deviation in the asset. Generally, investors can have a 5% threshold and check on deviation before rebalancing.
For example, Smriti has allocated 30% funds in Blue chips, 20% is towards Midcaps, 10% is in small-cap, and 40% invested in bonds. The tolerance limit is set at +/-5% for every asset class. In case the holdings move beyond the tolerance band, Ms. Smriti will rebalance to get back to the initial portfolio composition.
- Allocating new funds – Under this strategy, rather than selling the good performing assets and performing portfolio rebalance, the investor can add more money to the portfolio. In simple words, to maintain a certain asset allocation, the investor can add capital to the required asset class.
How often should you rebalance your portfolio?
Some investors, who are mostly day traders, check on their portfolios daily. While this is not essential for all, it doesn’t mean that the portfolio should not be checked at all. A periodic check on the portfolio’s performance is essential. If an investor is wondering whether he/she should consider portfolio rebalancing, here are some tips:
- Investors investing primarily in equities and debt, ETFs, mutual funds, bonds, and similar categories, should perform portfolio rebalancing at least annually.
- If you are closer to your goal then you should think of rebalancing at more frequent intervals (half-yearly/quarterly) just to make sure you are not caught on the wrong foot when you finally require your funds
Advantages of portfolio rebalancing
Here are some of the major benefits that can be availed from portfolio rebalancing:
- Managing risks – Portfolio rebalancing provides an opportunity to manage risks well. In any investment time horizon, risk tolerance can keep changing or the investments can fetch returns above or below expectations, sometimes as per expectations. By closely monitoring a portfolio, investors can amend asset allocation and contain the risks to stay within tolerable limits.
- Minimizing losses – Through regular rebalancing, investments can be aligned to market movements and this can help in minimising losses. The idea is to move out of investments that are loss-making and under-performing and opt for ones with better prospects. If this is done in time, an investor may be able to minimise losses. However, to identify such opportunities, requires continuous monitoring and some amount of expertise
Does portfolio rebalancing involve costs?
Rebalancing a portfolio can cost an investor depending on the extent of changes and frequency. Here are some of the portfolio rebalancing costs that investors must be aware of:
- Rebalancing often involves the cost of brokerage along with Securities Transaction Tax (STT) for investors who include stocks and bonds in their portfolio. These apply during buy/sell transactions of such securities.
- Exit load charges of approximately 2% are levied for mutual fund for sale transactions if made within a specific period from the start date.
- Short-term and long-term capital gains are applicable on the sale of equity/debt mutual funds based on the time over which you were invested.
Investors who consider asset allocation as an essential element in gaining actual returns must rebalance their portfolios from time to time. While portfolio distribution may initially seem complex, in reality, it is simple, especially once an investor begins understanding the portfolio construct and associated risk-return set-up.
- What is portfolio rebalancing, and why is it important?
Portfolio rebalancing means realigning the different asset weights in a portfolio to maintain the desired asset allocation as per individual risk appetite.
- What is the point of investment portfolio rebalancing?
Balancing a portfolio can ensure a good mix of investment assets such as stocks and bonds, as per individual risk tolerance and specific investment goals. It allows one to maintain the desired level of risk as per the investment time horizon.
- How do you rebalance a portfolio?
An investor can rebalance a portfolio by reviewing existing asset allocation, weighing the current risk-return profile against expectations, and buying/selling assets periodically.
- Does rebalancing a portfolio cost money?
If an investor has not hired any professional help, portfolio rebalancing does not cost any money but can involve transaction costs, exit loads, or taxes on the redemption of investments.
- Can portfolio rebalance improve returns?
Depending on the strategy adopted and individual goals, portfolio rebalance may generate better returns. This is also possible if the investor times his rebalancing as per market movements