The investment landscape is full of opportunities and potential pitfalls. It is constantly evolving and changing in sync with the changes in society.

Hence, as an investor, it is important to stay aware of the impact these changes are having on your investment portfolio and make changes to ensure optimum returns. This process of making changes to your investment portfolio is the fundamental concept behind portfolio rebalancing. 

Some Basics

There are two terms to be understood here – an investment portfolio and the balance of a portfolio. Let’s look at each of them separately:

What is an investment portfolio?

As complex as it may sound, an investment portfolio is simply a collection of all your investments. 

While most investors start investing in individual instruments like buying a certain share or mutual fund, etc., over time, they start looking at their financial goals and create an investment plan to meet their financial objectives. Typically, an investment plan considers three important aspects – 

  1. Financial goals;
  2. Risk tolerance; and
  3. The time horizon for which they want to stay invested. 

Each investor is unique, has a different understanding of the market and economy, and a different approach to investing. When investing according to a plan, they try to choose investments that work cohesively to help reach the goals in good time. 

There are various asset classes to choose from and multiple variants with each asset class too. For example, equity is an asset class and you have options like large/mid/small-cap stocks or banking/tech/healthcare stocks, etc. An investment portfolio offers a bird’s eye view of all your investments and helps you assess if they are working towards meeting your financial goals.

What is the balance of a portfolio?

Having understood an investment portfolio, let’s talk about the concept of a balance of a portfolio.

When you invest in multiple assets, the returns on all your investments depend upon the performance of those assets and the percentage of your portfolio invested in them. 

For example, let’s say that you have invested a total amount of Rs.10 lakh. Of this, you have invested Rs.7 lakh in stocks, Rs.1 lakh in debt funds, Rs.1 lakh in gold ETFs, and Rs.1 lakh in a real estate investment trust. In this case, your portfolio’s balance is skewed towards equity (70%). Hence, if the stock market rallies, then your portfolio generates good returns. On the other hand, if it nosedives, the negative impact can be tremendous too.

Hence, most investment experts recommend creating a portfolio that is balanced between various asset classes (and/or investments) to optimize profits while keeping risks in check. This is based on the risk tolerance of each investor. Hence, when you create a portfolio, your investment plan can help you decide the balance between investments that is best suited to you.

So, if we continue the example cited above, an investor with a higher tolerance to risks can create such a portfolio. However, two investors with similar risk tolerances can have different portfolios by choosing individual investments differently. So, while investor ‘A’ might choose to invest in small-cap stocks (for the equity portion) and AA-rated bonds (for the debt portion), investor ‘B’ might opt for large-cap stocks (for equity) and AAA-rated bonds (for debt). Hence, despite having similar exposure to asset classes, the risks can differ greatly.

Hence, investors create a portfolio that is balanced according to their profile in an effort to minimize risks without compromising a lot on potential returns.

What is Portfolio Rebalancing?

We hope that the concepts of an investment portfolio and the balance of a portfolio are clear by now. Next, we will talk about rebalancing a portfolio.

When you create a balanced investment portfolio, you consider the performance of various investments as on the date of investing and assess their potential returns. However, as time goes by, some instruments can under/over-perform. Also, as you age, your risk tolerance and financial goals can change. Hence, you need to revisit your portfolio and ensure that it syncs with the market and your goals. 

As a part of the rebalancing process, you must focus on not exposing your portfolio to unnecessary risk and try to keep it relevant to the changing times. Hence, you look at underperforming assets or investments and replace them with ones that show better promise. 

Example 1

To give you an example, if you had a portfolio with 50% in stocks, 30% in debt, and 20% in gold in January 2020 and by the end of 2020 if the debt portion of your portfolio is underperforming, then the overall returns of your portfolio can get impacted. Hence, you need to rebalance the asset allocation of your portfolio to ensure that the returns are optimized while keeping the risks minimal. 

Example 2

Here is another example: Let’s say that an investor creates a portfolio at the age of 25 years. The portfolio has 75% in stocks with moderate risks and 25% in low-risk bonds. Fifteen years later, when the investor turns 40, although the portfolio has performed well, his risk tolerance decreases due to multiple financial commitments. Hence, the current risk exposure of the portfolio may not be in sync with his tolerance. Hence, the investor needs to rebalance his portfolio by reducing the higher-risk investments and replacing them with lower-risk investments.

Benefits of Portfolio Rebalancing

Why should an investor consider rebalancing the investment portfolio? What are the benefits? Here is a quick look:

Managing Risks

As explained above, rebalancing your portfolio offers an opportunity to manage portfolio risks. With time, your risk tolerance can change or the investments can perform above or below expectations. By keeping a tab on your portfolio, you can make changes to the asset allocation and keep the risks with your tolerable limits.

Minimizing losses

By rebalancing regularly in-sync wth market movements, you can minimise your losses. If you are able to move your investments from loss-making and under-performing ventures to ones with better prospects, on time, you may be able to minimise losses. However, identifying such opportunities requires constant monitoring of your portfolio. 

How do I rebalance my investment portfolio?

There are many ways to rebalance your investment portfolio. Once you are clear with the concept, you can create a plan of action yourself. If you are looking for tips, here are some commonly used portfolio rebalancing strategies:

Periodic Rebalancing

This is the simplest rebalancing strategies that an investor can follow. Under this strategy, you mandatorily rebalance your portfolio after a fixed interval. You can choose the interval based on your preference like a week, month, quarter, six months, year, etc. Once you have determined the interval, rebalance your portfolio even if the required changes are small.

Threshold Rebalancing

Unlike the first strategy, this one does not depend upon the interval between two rebalancing processes. In this strategy, you rebalance the portfolio if an asset class moves from its target by more than x%. Let’s say that you want to create a portfolio with a 50% exposure to stocks. If you were to follow the threshold rebalancing strategy, then you can decide to rebalance if the equity portion of the portfolio changes by say 10%.

Volatility-based Rebalancing

In this strategy, rebalancing is done based on the volatility of the portfolio. To follow this strategy, you need to determine the expected volatility of the portfolio. When the volatility of a certain asset class increases beyond a certain threshold, then depending on your risk level you can rebalance your portfolio between low volatile and high volatile assets. 

When Should You Rebalance Your Portfolio?

Remember, in a portfolio, while some investments perform as per expectations and better, there will be a few that will underperform. While you should replace the underperforming investments, don’t be in a hurry to make changes. Allow your investments reasonable time to deliver returns and conduct fundamental research before making a decision. Here are some indicators that point towards a need to rebalance your investment portfolio:

The Portfolio not performing as expected

When you create an investment portfolio, it will reflect your risk tolerance, expected returns, liquidity requirements, and growth focus. So, if you are looking to create a corpus for buying a house (financial goal), then you might look at a combination of investments that help you generate wealth over time. Also, you will try to keep the risks moderate since buying a house is a critical life decision. 

Let’s say that you create a portfolio with 50% in stocks (large & mid-caps), 40% in debt funds (AAA-rated bonds), and 10% in gold ETFs. Over time, as markets change, the value of your investments will change too. Hence, the portfolio composition will be different from when you created it. Let’s say that after a year, the portfolio has 60% stocks, 35% debt, and 5% gold. This means that stocks have increased in value occupying a higher percentage of your portfolio. However, since stocks are riskier than bonds/gold, the over risk exposure of your portfolio increases. If you are not comfortable with this increased risk, then this can be an indicator to rebalance your portfolio and reduce the exposure to stocks.

Changes in Financial Goals

Life is a series of events – planned and unexpected. Hence, while you have a certain perspective about your life when you create an investment portfolio, circumstances can make certain goals redundant and force you to create new ones. For example, you might plan for marriage and a child but be blessed with twins throwing all your plans in disarray and force you to make the necessary alterations since you have to plan for two children instead of one. Many such situations can lead to a change in your financial goals. Usually, as we age, our risk tolerance levels fall since we tend to have more financial responsibilities. Hence, our investment portfolios need to be rebalanced to reflect the changing needs.

Performance of individual investments

A portfolio is the sum-total of individual investments. Hence, the performance of each investment contributes to that of the portfolio. If a particular investment that forms a reasonable part of your portfolio underperforms, then its returns can get impacted. Hence, whether you are rebalancing your portfolio or not, it is advisable to regularly monitor the performance of each investment. Once you identify a particular asset, sector, or investment underperforming with little or no scope of recovering, then switching it to more promising investments is a prudent ploy.

Summing Up

The portfolio approach to investing is preferred by most investors as it allows them to stay on top of their investments at all times. However, markets are inherently dynamic, and social, economic, political, and other macroeconomic factors can influence the way your investments perform. Hence, adopting the ‘invest and forget’ approach can be counterproductive. Ensure that you monitor the performance of your portfolio regularly and deploy some effective rebalancing strategies as per your preferences. Good Luck!