In the world of investment, it is natural for a portfolio’s balance to change over time. Equities may grow rapidly at times, while debt or gold can perform strongly at other times. These fluctuations can cause your investments to drift from their original allocations. This is where the concept of portfolio rebalancing comes in.
In this blog, we will explain what portfolio rebalancing is, why it is important, how it works, step-by-step methods to rebalance your investments, and the common mistakes to avoid. By the end, you’ll have a clear understanding of how to maintain a balanced portfolio aligned with your financial goals.
What Is Portfolio Rebalancing?
Portfolio rebalancing is the process of systematically realigning the weights of assets in a portfolio back to the target allocation defined by the investor’s risk profile, investment horizon, and financial objectives. It typically involves selling overweight assets and reallocating capital to underweight ones to maintain the intended risk-return characteristics.
When equities, debt, gold, or other investments drift from their target weights due to market movements, rebalancing brings them back in line with the original allocation. Its purpose is not just to increase returns, but to control risk and keep the portfolio aligned with your long-term financial goals.
Example : Suppose you invested 60% in equity and 40% in debt. If the equity market performs well and its proportion rises to 70%, the portfolio becomes riskier than originally intended. In rebalancing, you sell some equity and invest in debt securities, so that the ratio comes back to 60:40. In this way the portfolio remains in line with your risk tolerance.
How does Portfolio Rebalancing work?
The rebalancing process can be broken down into a few simple steps.
- Determining asset allocation : Initially, the investor decides the ratio (e.g. 70% equity, 20% debt, 10% gold) based on his goals, risk appetite and time horizon.
- Portfolio review : It is important to review the portfolio from time to time to see how the ratio has changed.
- Identifying deviation : Generally, deviation of more than 5% is considered a signal for rebalancing.
- Taking action: Sell overweight assets and allocate money to underweight assets or allocate new investments there.
- Repeat : This process is repeated annually, half-yearly or on a fixed schedule.
Why Is Rebalancing Important?
- Risk management : When the market is bullish, the proportion of equity often increases and this can make the portfolio more risky. By rebalancing the portfolio, the investor ensures that there is no excessive investment in any one asset class and one does not have to suffer a huge loss in case of a sudden decline.
- Alignment with long-term goals : Every investor has different goals such as retirement, children’s education or buying a house. Rebalancing ensures that your portfolio helps you achieve these goals. For example, if there are only 10 years left for retirement, it is safer to increase the proportion of debt.
- Avoid emotional decisions : Often investors make wrong decisions due to greed or fear. In a bull market, one does not feel like selling equities, whereas in a decline it is common to panic and withdraw everything. Rebalancing avoids this cycle and inculcates the habit of disciplined investing.
- Protection from volatility : Volatility is very high in emerging markets like India. During Covid-19, the stock market fell by 35%, while the debt and bond markets were affected by the increase in interest rates in 2021–22. If the investor had maintained balance at that time, the loss would have been less and the recovery would have been faster.
- Historical evidence : Many studies show that balanced portfolios perform better in the long run than those portfolios that become unbalanced. Constant balancing may reduce short-term gains a little, but it provides stable and sustainable returns.
How to Rebalance Investments?
Step 1: Define Your Asset Allocation
Start by setting a clear target mix, such as 60% equity, 30% debt, and 10% gold. This allocation should reflect your financial goals, time horizon, and risk tolerance. It acts as your reference point, ensuring you know when your portfolio drifts away from your original strategy.
Step 2: Review Your Portfolio
Periodically check your current investments to see how much they differ from your target mix. Over time, market movements can cause equities, debt, or gold to shift from their planned ratios. A deviation of 5 to 10% usually signals it’s time to take action and restore balance.
Step 3: Select a Rebalancing Approach
Choose a rule for when you will rebalance. With a calendar-based approach, you reset allocations at fixed intervals, such as every six or twelve months. With a band-based approach, you act only when allocations move outside a set range. Both methods bring discipline and consistency to your investment strategy.
Step 4: Reallocate Efficiently
When rebalancing, start with the most cost- and tax-efficient method first. Direct fresh investments or dividends received into underweight assets, rather than immediately selling overweight holdings. If selling is necessary, consider taxes, brokerage costs, and exit loads before making changes. The aim is to realign your portfolio without unnecessarily reducing returns.
Step 5: Monitor and Stay Disciplined
After rebalancing, record the changes made, the reasons, and the new portfolio allocations. This habit builds discipline and helps with future decisions. Sticking to a written plan prevents emotional investing during market highs and lows, ensuring your portfolio remains aligned with long-term financial goals rather than short-term market swings.
Advantages and Disadvantages of Portfolio Rebalancing
Advantages of Portfolio Rebalancing
- Risk Management: When your money is invested across different asset classes (such as equity, debt, gold), the entire portfolio is not affected if there is a fall in any one asset. Rebalancing your portfolio at regular intervals ensures this.
- Discipline in investing : Often people take decisions emotionally by seeing market movements. Rebalancing helps in sticking to a fixed plan and strengthens the long-term strategy.
- Improved Returns: By selling assets that have become overweight and adding to undervalued options, returns can be smoothed and made more consistent over time.
- Match with goals : Every investor has different goals—such as retirement, children’s education, buying a house. Rebalancing keeps the portfolio adjusted according to these financial goals.
- Reducing volatility: Markets will always fluctuate, but a balanced portfolio helps absorb sudden shocks and ensures steadier, long-term growth.
Disadvantages of Portfolio Rebalancing
- Expenses can increase : Every time you change your portfolio, you have to pay brokerage, tax and transaction charges. These expenses seem small, but can reduce returns in the long run.
- Requires time and effort : Rebalancing is not just buying and selling. It requires constant monitoring of market trends, data and performance of assets. This task can be challenging for busy investors.
- Short-term impact : Sometimes better performing assets have to be sold and new investments take time to give results. Due to this, short-term returns can decrease.
- Frequent Rebalancing: Changing portfolio allocations too often can reduce stability. Constant rebalancing may lower long-term returns due to taxes, brokerage fees, and other transaction costs.
- Timing risk: If rebalancing is done hastily without proper analysis, it may lead to buying high or selling low, which can hurt portfolio performance.
Common Mistakes to Avoid
Portfolio rebalancing is an important step to keep investors on track. But sometimes people make small mistakes and harm their investments. Let’s know the common mistakes that are important to avoid:
- Rebalancing too often : Some investors start changing the portfolio after every small fluctuation. Doing this can increase unnecessary trading costs and tax burden. The right way is to review annually or once in 6 months.
- Ignoring tax and transaction costs : Tax and brokerage charges may be levied on selling mutual funds or stocks while rebalancing. Ignoring these can reduce the actual return.
- Making decisions with emotional bias : Often investors hesitate to sell a “winner” i.e. a well-performing asset. But sometimes that is what has to be done to maintain balance.
- Copying others : Every investor has different goals. Copying someone else’s portfolio will not meet your needs. Always rebalance according to your financial goals.
- Forgetting long-term goals: When rebalancing, it is crucial to consider major financial goals such as retirement, children’s education, or buying a house. Ignoring these objectives can lead to a funding shortfall in the future.
Conclusion
While investing, it is not enough to simply allocate money correctly; it is equally important to manage it consistently over time. Portfolio rebalancing at regular intervals helps you achieve this by keeping your investments aligned with your goals and risk tolerance. Frequent changes are unnecessary, but rebalancing at fixed intervals minimizes risk and promotes better long-term results. Done thoughtfully, rebalancing strengthens your overall investment strategy.
Frequently Asked Questions (FAQs)
What is portfolio rebalancing?
It is a process in which portfolio assets are readjusted to their target allocations according to your goals and risk tolerance.
How often should I rebalance my portfolio?
It is better to do it 1–2 times a year.
Does rebalancing reduce risk?
Yes, it reduces risk by keeping allocations balanced and returns more stable.
Is portfolio rebalancing costly?
Brokerage charges and taxes may increase if portfolio rebalancing is done frequently.
What is the main benefit of rebalancing?
It keeps your investments allocations aligned with your goals and risk profile.
