Comprehensive Guide to Portfolio Rebalancing

June 24, 2022

Rebalancing is the process via which an investor restores their investment portfolio to match their target allocation! And let’s face it, no investor likes to put all their funds over the same asset class. Moreover, it has always been important to realign the weights of all your assets and securities to facilitate better asset allocation and risk mitigation.

However, most people are still unaware of the ideal approach to go about this entire ordeal! For starters, this entire process is conventionally known as portfolio rebalancing.

In most cases, people use this strategy once a year. Thus, let’s dive deeper and get a better understanding of what portfolio rebalancing is all about.

What Exactly Is Portfolio Rebalancing?

This is a process where an individual will review and restore asset allocation to match it with the target allocation. The target allocation is basically set after risk profiling or analyzing risk taking ability of an individual. Portfolio Rebalancing acts as a fail-safe mechanism by keeping your investments with in the set limits and prevents over exposure to some asset classes. Many even refer to it as the weighted method of a given portfolio of assets.

For instance, suppose you as an investor choose a target allocation strategy of 50% into debt and 50% equity but after a certain amount of time, the asset allocation reaches 65% in equity for some reason. In such scenarios, restoring the asset allocation to its original value becomes imperative.

This is important because any losses or gains in the future depends on it. Thus, asset realignment is your best bet to maintain an ideal risk and return ratio.

Furthermore, doing away with all underperforming assets and investing in new and better performant assets can also be termed portfolio rebalancing. This means whenever you see your investments are not performing effectively to realize your expectation; it is better to leverage good financial planning and realign the assets.

Working Principle of Portfolio Rebalancing

The basic motive behind portfolio rebalancing is to safeguard the investor from any unwanted risk or even overexposure to risk. This means that portfolio rebalancing is key to keeping the risk factors under check and also evaluating the investor’s tolerance level. The debt and equity holding ratio can influence the performance of your portfolio to a great extent.

In addition, the overall expectation also undergoes significant changes to meet the ever-changing financial requirements. As a result, it becomes very important to even change asset allocation and rebalance the portfolio to meet the requirements that arise along the way. To avoid this, An effective goal based financial planning will help you to identify and prioritize goals and avoid too many changes. When goals are fixed and priority is well established, you know what is important and what is not. Also, when your goals are long term and if your asset allocation is more towards equity, you might want to change your asset allocation strategy towards debt when the duration reduces and there is only less than five years for the goal to be realized.

Furthermore, there are different strategies used for portfolio rebalancing. Picking the appropriate strategy is very important. These portfolio rebalancing strategies include:

Tolerance Band Rebalancing

This is an approach where the investor leverages the percentage deviation approach to rebalance and align the assets with their original value. One can have a threshold of 5% and continue to revisit and check the deviation and rebalance accordingly.

For instance, suppose you have 20% in blue chips, 30% in mid-caps, 10% in small caps, and the remaining 40% in debt. The investment in all these assets comes with a tolerance of plus or minus 5%. Thus, when the asset holding exceeds the tolerance level, you will need to rebalance and reflect back on the initial composition.

Periodic Rebalancing

This is a relatively simpler strategy for portfolio rebalancing as this allows the investor to evaluate their holdings at a given time and date. In addition, one can set these investment revisits on an annual basis for better convenience. This is a widely used approach as it is far less time-intensive and demonstrates discipline.

Should You Consider Portfolio Rebalancing?

If you are a day trader, you likely evaluate on a daily basis. However, this is not an ideal approach for an investor, as micromanaging can be detrimental to the investor’s interest.

Also, that does not mean that you should invest and simply forget about it as an investor. Instead, a regular check is an ideal way to determine the performance of the investment and make decisions accordingly.

Investors who pour their investments and resources into debt and equity such as mutual funds, shares, bonds, ETFs, or other debt securities. It is recommended that you take a look at the portfolio rebalancing at least once every year.

In Conclusion

Portfolio rebalancing is very important for every investor as it helps them better manage their investments and increases the chances of generating good returns. However, one should be mindful of the fact that portfolio rebalancing impacts trading costs, and other similar expenses. Therefore, you should consult an expert or master these skills by yourself to ensure you spend little and earn more.