Rebalancing is the process by which an investor restores their portfolio to its target allocation. Rebalancing brings your portfolio back to the desired asset mix. This is done by reinvesting the profits that are taken out of some of the outperforming investments and putting them into under performing assets.


Why Rebalancing ?

Rebalancing is bringing your portfolio back to your original Asset Allocation mix. This is necessary because over time some of your investments may become out of alignment with your investment goals. You’ll find that some of your investments will grow faster than others. By rebalancing, you’ll ensure that your portfolio does not overemphasize one or more asset categories, and you’ll return your portfolio to a comfortable level of risk.

For example, let’s say you determined that stock investments should represent 60% of your portfolio. But after a recent stock market increase, stock investments represent 80% of your portfolio. You’ll need to either sell some of your stock investments or purchase investments from an under-weighted asset category in order to re-establish your original asset allocation mix.

When you rebalance, you’ll also need to review the investments within each asset allocation category. If any of these investments are out of alignment with your investment goals, you’ll need to make changes to bring them back to their original allocation within the asset category.

Changing Your Asset Allocation

The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you’ll likely need to change your asset allocation. For example, most people investing for retirement hold less stock and more bonds and cash equivalents as they get closer to retirement age. You may also need to change your asset allocation if there is a change in your risk tolerance, financial situation, or the financial goal itself.

But savvy investors typically do not change their asset allocation based on the relative performance of asset categories - for example, increasing the proportion of stocks in one’s portfolio when the stock market is hot. Instead, that’s when they “rebalance” their portfolios.

How to do it ?

When you invest in mutual funds, you are basically investing to achieve a single goal via various vehicles. So when you rebalance, the shift must occur across all of these funds at the same time.

Here’s how you can rebalance your portfolio in 5 simple steps:

Step 1: First and foremost, have an asset allocation plan by taking into consideration your income, the expected time of retirement, etc. Create an asset allocation framework first.

Step 2: Assess your current asset allocation by identifying where and how your current investments are placed on stocks, cash, bonds, or any other form of investment. Post this analysis make a comparative analysis of asset allocation target and its present state and accordingly make adjustments.

Step 3: Chart out a rebalancing plan is your asset allocation target does not align with your current portfolio. This step of the rebalancing process can seem a bit intimidating where you have to decide which securities to keep and in what numbers.

Step 4: Be mindful of the tax implications, especially on capital gains. Avoid the short term taxes on capital gains by holding on to your equities for over a year. In case of debt funds, the short-term capital gains will qualify for taxes based on the individuals’ income tax slab. For long-term 3 years capital gains, the tax is 20 percent with indexation. If you need to scale back, aim to sell the securities in the tax-exempt accounts first. That way, you’ll limit the taxes you pay in capital gains.

Step 5: Review your portfolio at least once a year or maybe once in 6 months to assess your position but rebalance it only when you feel that the allocations are significantly out of the track to reaching the target.

When to Consider Rebalancing

You can rebalance your portfolio based either on the calendar or on your investments. Many financial experts recommend that investors rebalance their portfolios on a regular time interval, such as every six or twelve months. The advantage of this method is that the calendar is a reminder of when you should consider rebalancing.

Others recommend rebalancing only when the relative weight of an asset class increases or decreases more than a certain percentage that you’ve identified in advance. The advantage of this method is that your investments tell you when to rebalance. In either case, rebalancing tends to work best when done on a relatively infrequent basis.

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