Portfolio re-balancing is one of the most important step in the process of investing. Investing in any type of security, be it stocks, bonds or mutual funds; re-balancing is essential, to say the least.

Change- in the investing process or cycle- is what is referred to in this article as rebalancing, or specifically portfolio rebalancing.

To drive home this need for change, readers can ponder upon the thought that- what worked a generation ago, may not necessarily work in today’s generation.

For that matter, what worked as recent as yesterday, may not work with the same effect today. It is required that one constantly changes one’s way of operation to suit the present day needs.

Portfolio rebalancing does exactly that.

It enables an investor to change his investment position in accordance with the change in the current market fundamental scenario and any other variable. This could be in terms of his/ her exposure to various securities- the proportion of exposure, investing in new securities, investing out of old securities, etc.

One wouldn’t want to be in a position wherein the market situations changed for the worse or better. But due to no proactive portfolio rebalancing measure, the investor missed out on saving oneself from bad market performance or picking out a good investment opportunity.

In this article, we cover what portfolio rebalancing actually means, why is it important for any investor and how can one effectively balance one’s portfolio and beyond.

What Is Portfolio Re-Balancing?

Before looking at rebalancing, let us first understand what a portfolio actually means.

Portfolio in the very basic sense is nothing but a collection (visualize portfolio as a basket) of, possibly different, securities. A portfolio is a collection of different securities taken as a single unit.

To take a small example, assume you have ₹1,00,000 to invest. You invest ₹60,000 in stocks, ₹25,000 in government securities, ₹10,000 in bonds and ₹5,000 in gold.

Let us look at your portfolio rebalancing.

Re-balancing is essentially changing the proportion to meet the new objective or purpose.

Basically, portfolio rebalancing is the process of modifying the asset allocation within a portfolio.

Portfolio rebalancing can be explained with the help of the following example.

Suppose an individual is 25 years old. Today, he invests 75% of his total investments in stocks with moderate risk and the remaining 25% of his investments in low-risk bonds.

Fast forward 15 years, now he is 40 years old. Though his investment in stocks has performed well in the past 15 years, his risk taking capacity has decreased, due to various commitments, need for savings and other reasons.

As the risk capacity has changed, so is the requirement for a change in the asset allocation within his portfolio. He/ she needs to reduce the risky investment in stock from 75% to say 60%. This needs to be replaced with a less risky investment in say, bonds or government securities from 25% to say 40%.

This change in the asset allocation within the portfolio of the individual is called portfolio rebalancing.

Benefits of Portfolio Re-Balancing

Portfolio re-balancing has two-fold benefits. They are as follows-

1. Reduction of Risk

After the investor has decided on the level of risk he wants to take, it is important to periodically re-balance in order to maintain that risk profile.

Example, say the underlying risk of a mutual fund scheme is changed to highly risky from moderately risky. Now, if this risk exceeds the tolerable risk limit, rebalancing and exiting from the scheme is essential, in order to keep the risk-level in check.

2. Increased returns

Selling under-performs and investing in potential star-performers is not only a smart move but also a necessary one. Example, say a particular stock has been facing management issues and its price has dropped heavily and still falling. At this point in time, it becomes essential to exit this stock and invest elsewhere.

This would not only prevent further losses but also lead to the tapping of a new opportunity and increased future returns.

Re-Balancing Strategies

Following are the common ways of re-balancing one’s portfolio:

1. Periodic Re-balancing

In this fairly simple strategy, the portfolio is re-balanced after a fixed time interval decided by the investor. The time interval could be as frequent as daily, weekly or as long as one wants. Once the interval is decided then the re-balancing must necessarily take place, no matter how small the change may be.

For this purpose, determining the frequency of re-balancing is important to know the risk-appetite of the investor along with some other factors such as portfolio assets and re-balancing cost.

2. Threshold Limit Re-Balancing

This strategy ignores the time aspect of re-balancing, stated above. As per this strategy, the investors shall re-balance the portfolio only when the portfolio’s asset allocation has drifted from the target asset allocation.

The rebalancing process as per this strategy is triggered only when the drift exceeds a predetermined minimum rebalancing threshold such as 5% or 10%, as defined. It must be kept in mind that the threshold triggers rebalancing regardless of the frequency.

Due to the above independence, the rebalancing could be triggered as frequent as daily or as infrequent as every five years. This depends on the portfolio’s performance relative to its target asset allocation.

3. Combined Re-Balancing

This strategy rebalances the portfolio on a periodic basis, but only if the portfolio’s asset allocation has drifted from its target asset allocation by a predetermined minimum rebalancing threshold.

To put this simply, say on the scheduled rebalancing date, the portfolio’s deviation from the target asset allocation turns out to be a figure less than the predetermined threshold. In the given case, this strategy calls for the portfolio not to be rebalanced.

Similarly, if there is a drift in the portfolio’s asset allocation by the minimum threshold or more at any intermediate time interval, the portfolio shall not be rebalanced at that time.

When Should You Re-Balance Your Portfolio?

After knowing the importance of rebalancing one’s portfolio, it is equally important to know when an investor should rebalance. The main objective of a portfolio is to ensure that the investor stays on track and reaches his/her financial goals on time.

However, there may be instances such as market volatility and certain global events when the portfolio can lose its way. Moreover, it is also possible that the financial goals of the investor changes. Or, it may so happen that the portfolio is not able to meet the needs of an investor.

This is the point in time when an investor should proactively intervene. An investor needs to take a step back, analyze the scenario, analyze his portfolio and re-align his strategy if required.

In essence, a portfolio requires periodic course corrections to ensure that its allocation is in line with the investor’s preference for risks and returns. Some of these scenarios generally faced by the investors are:

1. Portfolio Drifting Away From Investor’s Preference

The initial asset allocation of the portfolio reflects the investor’s risk capacity, return expectation, need for growth, income and liquidity. This is also possible without any intervention whatsoever.

For example, assume you started with an equal share of equity and debt in your portfolio. Now over the course of time, as markets grow and change, the share of equity and debt in the portfolio will also change.

Now, your portfolio would have drifted away from your initial preferences. This can happen without your intervention. However, this new allocation would inadvertently expose you to higher (different) risks than you intended to be in.

Such a drift in asset allocation within a portfolio is a trigger to rebalance the portfolio. This helps to keep the portfolio’s risk and return characteristics consistent with that of the preferences of the investor.

This can be simply done by reducing exposure to the asset class whose allocation has increased beyond what was intended. While also adding to the asset class whose share in the portfolio has fallen.

2. Life Events and Goals

The next general requirement for re-balancing is when a change in the circumstances of the investor triggers a change requirement in asset allocation and portfolio composition.

The change in circumstance could be the life cycle change such as marriage, a child’s education, retirement and others. These are common situations which greatly alter the portfolio asset allocation requirements.

Investors in the early stages of their careers can generally target liquidity and growth in their portfolio. They would be willing to take comparatively greater risks and seek greater returns.

Later on as they move towards the next stages in life, the risk and return preferences change. Investors generally tend to have lower risk-taking capability and prefer stable incomes. The asset allocation needs to reflect the same, say be reducing the exposure to equities.

As retirement comes closer, the portfolio will primarily have to change its asset allocation, in order to reflect the need for regular income.

3. Performance of Individual Investments

A poor-performing investment such as a stock in equity can also have a significant impact on the portfolio’s returns. More so if that particular investment constitutes a big part of the portfolio.

It is advisable to periodically review all the investments underlying a portfolio on a periodical basis. Market events keep on changing from time to time and small events at the domestic or even international level could significantly affect the value of the asset.

In this light, the performance of various asset constituents should be tracked regularly. If there is any constant underperformance by a particular asset or a group of assets, then it is important to switch the investment to other products in the same asset class.

Conclusion

Markets and asset values change all the time. They are affected by a lot of known and unknown factors both domestic and international. Rebalancing helps this change and gears the investors to respond accordingly.

The financial goals and objectives of the investors change from time to time. It is very important to acknowledge and respond to these changes. Rebalancing helps in aligning the portfolio according to the new or present circumstances. It helps investors keep moving in the right direction towards their investment goal.

Happy investing!

Disclaimer: the views expressed are of the author and do not reflect those of Groww.