When is the right time to rebalance your mutual fund portfolio?

What is portfolio rebalancing?

After you make your investment portfolio, it doesn’t mean that your job is done. Its always advised keeping a tab on your investments to see if the actual returns are on track with your expected returns. If not, that’s when portfolio rebalancing will come in to picture. The primary objective of rebalancing is to establish better risk control and ensure that the portfolio isn’t dependent on one single property/characteristic. For most, the process of rebalancing is time-consuming and complicated and hence they avoid it altogether.

Balancing Act of Asset Allocation

Before getting into the process of rebalancing, first let’s understand balancing. Balance of an investment portfolio consists of its asset allocation and underlying investment types. To give you an example, while investing you would have chosen to have 80% exposure to equity and 20% to debt. This asset allocation is based on reviewing your profile, investment objective and risk tolerance. Therefore, while investing, striking the right balance is also important.

Why should you rebalance your portfolio?

The two main reasons why you should rebalance your portfolio. First, to keep the risk level within sustainable limits. Second, to take advantage of the market phase, and invest in cheaper valued assets.

Though its very tempting to hold more units of a fund that has outperformed, its not called rebalancing. Remember the asset allocation used during building your portfolio? You need to keep a tab of the asset allocation, as a slightest deviation can increase the risk in your portfolio. Hence restoring the original allocation will keep the risk within your tolerance limit.

A diversified portfolio spreads investments across multiple assets, even if one doesn’t perform well, the other tries to balance it out. Portfolio rebalance helps in reviewing the portfolio and assessing if they are the funds that you still want to hold in your portfolio.

Rebalancing when equity-debt gets out of sync is better than doing it based on market conditions. Instead focus should be on your own portfolio and rebalance when called for, this will ensure you book your profits in a timely manner.

How often should you rebalance your portfolio?

The easiest and practical way to rebalance is by reviewing your asset-allocation on a yearly basis. A divergence of 5% from the original asset allocation is when you should consider rebalancing. For example, if your target allocation is 70% equity and over time it becomes either 65% or 75%, then you should rebalance your portfolio. This 5% threshold doesn’t lead to frequent rebalancing but during a rally or underperformance, you can take corrective action on time.

How to rebalance your portfolio?

Perhaps this is the most important question. There are two strategies, however, none of them will guarantee returns. Its important to pick the right strategy for your rebalancing.

  • Periodic Rebalancing: Decide a time period and make sure you revisit your investments. Target to revisit your investments annually.
  • Tolerance Band Rebalancing: Here rebalancing to align with your original asset allocation is done by the percentage deviation in the asset. Have a 5% threshold and keep revisiting to check for this deviation and rebalance accordingly.

Let’s assume you have Rs 60,000 in equity and Rs 40,000 in debt. Over a period of time, your investments grew, with Equity at Rs 1,50,000 and Debt at Rs 80,000. Following are the options available to rebalance your portfolio:

  • Redemption: Redeeming the assets that have grown is one strategy. From the above example, you new asset allocation is 65:35. To restore to the original allocation you’ll have to redeem Rs 30,000 from equity. However, this isn’t a recommended exercise as it would reduce your investment value and would impact your goal.
  • Fresh Investment: Through this, you’ll have to bring in more investments to the assets that are lagging behind. Therefore, for the above example, you’ll have to invest Rs 20,000 in debt to restore the original asset allocation. However, keeping on increasing the investment in the asset that lagging behind is also not the right decision.
  • Switch: In this, you’ll have to switch between asset classes. Switching from asset class where the allocation as gone up disproportionately into the asset class where the allocation is lagging behind. From the above example, a switch of Rs 12,000 into debt from equity is required to maintain the original asset allocation proportion. This will include taxes and is suitable when its not viable to get in fresh investments.

Costs involved in rebalancing

Rebalancing is not free of cost. It comes with certain expenses.

  • Brokerage Cost: Includes the cost of buying and selling assets.
  • Exit Load: Mutual Funds charge certain percentage of exit load if funds are withdrawn within a specific time.
  • Taxation: Mutual funds attract short term and long term capital gains tax.

Portfolio rebalancing is about identifying and implementing a strategy to keep your investments on track to achieve your goals. A strategy that suits your friend wouldn’t suit you. Therefore, try to design a rebalancing strategy that would match your investment style. At the same time, you need to keep in mind the costs involved towards the decisions. The mantra should be, continuously monitor your investments rather than invest and forget.

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