Every investor strives to maximize the returns on their investment while minimizing their risk. To achieve this goal, many AMCs and sole investors look forward to rebalancing their portfolios. Portfolio rebalancing is required to maintain equilibrium in an inherently volatile market. This method is equally effective for retirees and young investors.
Portfolio rebalancing is required to maintain equilibrium in an inherently volatile market. This method is equally effective for retirees and young investors.
This article will teach you everything you need to know about portfolio rebalancing, including different strategies to employ and when to consider adjusting your portfolio.
What is Portfolio Rebalancing?
Rebalancing a portfolio entails adjusting the asset allocation within it in order to keep it in line with the investor’s desired risk and return profile. It involves purchasing and selling assets on a regular basis in order to restore the portfolio’s original asset allocation.
The process of dividing an investment portfolio among different asset categories, such as stocks, bonds, and cash, is known as asset allocation. Asset allocation assists investors in balancing the risk and reward of their investments, which is a necessary step in the rebalancing process.
Let’s understand this through an example.
Ayushman, a risk-averse investor or a low risk taker, prefers investing more in bonds than in stocks. The reason for this is that bonds provide fixed and periodic interest rates as compared to the volatile equity. In this case, the investor might invest 70%-80% in bonds and the remaining 30%-20% in equity.
Similarly, an investor named Anurag seeking a high return with a high-risk tolerance will invest less in bonds and more in equity. In this case, the scenario is reversed, with 70%-80% invested in equity and the remaining 30%-20% in bonds. Again, an investor seeking an average return will invest 50% in bonds and 50% in stocks.
Strategies Used for Portfolio Rebalancing
There are three common strategies which are being used to rebalance different portfolios.
- Calendar Rebalancing: This is the most basic type of rebalancing. Setting a defined date or time interval, such as quarterly or annually, to examine and alter the portfolio is part of this technique.Investors must decide on the optimal rebalancing frequency. Their time restrictions, transaction cost tolerance, and value drift allowance will determine the frequency. Calendar rebalancing provides certain advantages over more frequent techniques because it takes less time and is less expensive for the investor. It involves fewer rebalancing events and, potentially, fewer trades.
- Percentage of allocation or Threshhold Balancing: Every asset is assigned a specified tolerance level under this technique, and when an asset class falls outside of that tolerance threshold, the portfolio is rebalanced. For example, suppose you have a 5% band in which you do nothing if your allocation deviates by +/- 5%. A rebalancing is triggered if your allocation differs by more than 5%.
- Combination of buying and Rebalancing: Rebalancing your portfolio when you invest more money is a third portfolio rebalancing approach. Assume, for example, that bonds are underweight in your portfolio. Purchase bonds the next time you invest to help put your portfolio back into balance.
This method is simple and effective since it reduces transaction costs. (such as trade commissions and potentially capital gains taxes on asset sales).
How to Rebalance a Portfolio?
- Reviewing Asset Allocation strategy: At the very first step, one should identify and review the asset allocation strategy by denying those asset classes that have deviated from the planned allocation. If you’re using a tolerance threshold, you must determine whether an asset class has deviated sufficiently to cross that threshold.
- Sell and buy to Rebalance: To bring investments back into line, sell investments in asset classes that exceed the planned allocation. Then, with the proceeds from the sale, invest in the asset classes that have fallen below the desired allocation.
- Tax Factor: Be cautious of the tax implications, particularly with regard to capital gains. Holding your equities for more than a year allows you to avoid paying short-term capital gains taxes. If you need to cut back on your spending, try selling or eliminating stocks in tax-exempt funds first. This method allows you to save money on capital gains taxes.
Importance of Portfolio Rebalancing
- Efficient Management of Risk: The risks associated with a particular item can shift over time. Some growth stocks may stabilize and their risk levels may fall. Some assets may become more risky. You may need to reassess the risks in your portfolio and, if necessary, adjust the asset mix. Systematic portfolio rebalancing helps you to regulate the amount of risk you take.
- Adjusting New plans or Strategy: As you get older and more experienced, you may discover new strategies. Most investors become risk-averse as they age. Regular rebalancing of the portfolio will make your investments more dynamic and flexible in changing with the new plans or strategy.
- Efficient Tax Planning: If you are a small investor, you may want to consider redeeming your stocks at the end of the fiscal year and investing the proceeds elsewhere. This will not only help you book profits, but it will also help you spread your tax liability evenly over the years. Similarly, you can plan to redeem your investments in such a way that you can carry forward any previously incurred capital gain losses or set them off against future capital gains to save taxes.
- Maintaining the Asset Mix: The returns from each asset may vary. They could be in the form of earnings or capital gains. You may make some investment decisions without considering your asset mix. As a result, the asset mix of your portfolio may shift over time. As a result, the risks and expected returns of your investments may no longer suit you after some time. This could be remedied by rebalancing your portfolio.
Through Portfolio Rebalancing an investor can secure their returns and have the different choices to direct his/her investments as per their risk appetite. This provides investors an edge to change their asset allocation strategy as per their requirements. Therefore, a balanced portfolio is essential if you want to generate long-term wealth through your investments.