As the name suggests, rebalancing means helping regain the balance. When the reference is to an investment portfolio, it means reverting to the original asset allocation or portfolio composition. This is done by buying or selling different assets so that the initial balance or weightage of assets is retained. An investment portfolio is built with different assets— equity, debt or fixed income, real estate, gold—in a specified proportion or percentage. This depends on the investor’s financial goals, time horizon, risk appetite, returns from assets, etc.
Now, suppose the market is in a bull phase and the equity component earns very high returns. This means the proportion or value of one asset (equity) will increase, while that of another (debt) will drop due to differing returns, altering the original equity-debt mix. This altered weightage needs to be returned to the initial balance by buying or selling assets.This is done to reduce losses from any potential market dips and ensure that you reach your goals with the required goal values.
HOW TO REBALANCE A PORTFOLIO
You will realise the need to rebalance your portfolio only if you monitor it periodically, whether it is quarterly, half-yearly or annually. This should also be done if the markets have faced high volatility and altered your asset mix.
Know original asset mix: To be able to rebalance, you need to know the initial asset allocation you have set for yourself in accordance with your goal values, horizon and risk tolerance. Let’s assume you have invested 60% in equity mutual funds and 40% in debt funds. Within equity, you could have invested in large (30%), mid (20%) and small caps (10%). Remember to tabulate and make a note of this asset mix.
Calculate the deviation: During the periodic review or after market fluctuation, check this assest mix. For instance, in the past couple of years, the mid- and small-cap returns have surged, which would have raised your equity allocation considerably. So, instead of 60%, your equity percentage could have risen to, say, 66%, lowering the debt composition to 34%.
Buy or sell: To rebalance, you will need to sell from equity funds (small and mid caps) and buy debt funds, so that you can return to the original mix of 60% equity and 40% debt.
Check tax implication: While selling equity or debt, check the relevant capital gain and taxation. You can then decide to sell the stock or redeem the fund that reduces your tax liability. Currently, long-term capital gains in equity are taxed at 12.5% (above `1.25 lakh a year), and short-term gains at 20%. Long term means an asset held for over 12 months.PROS & CONS
Controls risk: Rebalancing helps manage portfolio risk. If your equity component has surged with the market rise, in case of a sudden dip, your portfolio will suffer a higher loss due to the higher equity proportion. Rebalancing and lowering the equity component would have curtailed this loss.
Reach target: If you have calculated your goal value as per the returns from different assets, and the asset mix is altered due to fluctuation, you may end up with losses and run short of the required funds close to a goal. Rebalancing helps prevent this.
Higher costs & losses: If you do not calculate tax liability or rebalance too frequently, you could end up paying higher transaction fees and tax. Also, reabalancing at the wrong time could result in higher losses.