Portfolio rebalancing is a crucial investment strategy that helps investors maintain their desired asset allocation over time. It involves adjusting the holdings in your portfolio by buying or selling assets to return to the original target allocations. This process plays a key role in managing risk, improving returns, and ensuring that a portfolio remains aligned with an investor’s goals.
Imagine an investor who has decided to allocate 60% of their portfolio to equities and 40% to bonds. Over time, due to market movements, the value of equities may increase more rapidly than bonds, shifting the portfolio to a 70/30 split. To return to the original 60/40 balance, the investor would sell a portion of the equities and reinvest those funds in bonds. This is the essence of portfolio rebalancing.
Why rebalance your portfolio?
The primary goal of rebalancing is risk management. While rebalancing may slightly lower potential returns in the short term, it reduces portfolio volatility and improves long-term risk-adjusted returns. Here’s why rebalancing matters:
When to rebalance: triggers for action
There are several rebalancing triggers that help investors decide when it’s time to make adjustments:
- Time trigger: Rebalancing occurs on a set schedule, regardless of market performance or asset price movements. This could be done monthly, quarterly, or annually. The primary advantage of this trigger is simplicity, as it doesn’t require investors to monitor market fluctuations continuously. For example, an investor in India, say Ravi, has a portfolio of ₹10 lakh, consisting of ₹6 lakh in equities (60%) and ₹4 lakh in bonds (40%). Ravi decides to rebalance his portfolio annually.
- Threshold trigger: Rebalancing happens only when the value of one asset class deviates by a specified percentage from its target allocation. For example, if Shubham’s portfolio shows a 5% deviation in any asset class (equities or bonds), he will rebalance.
- Combination trigger: This strategy combines both time and threshold triggers. It involves rebalancing at set intervals but also allows for adjustments if the asset allocation deviates beyond the predetermined threshold. This approach is often considered the most effective as it balances regular maintenance with responsiveness to market shifts. For example, Varun now uses a combination strategy: he will rebalance annually (time trigger), but if any asset class deviates by 10% from the target allocation, he will rebalance earlier.
Best practices for rebalancing your portfolio
To ensure that your portfolio stays on track, it’s important to follow best practices:
Conclusion
Portfolio rebalancing is an essential tool for managing risk and ensuring that your investments remain aligned with your financial objectives. By regularly rebalancing your portfolio, you can reduce exposure to risk, capture profits, and improve long-term returns. Whether you use time, threshold, or combination triggers, following a disciplined approach to rebalancing can help protect your investments and provide a better risk-adjusted return. With a clear plan in place, you can navigate market fluctuations and remain on track to meet your financial goals.
Rohit Gyanchandani is Managing Director at Nandi Nivesh Private Limited
