What Is Portfolio Rebalancing And Why Is It Important?

Want to know what is portfolio rebalancing and why is it important? As the name suggests, portfolio rebalancing means realigning the weight of capital allocated to different asset classes.

This is done to maintain the originally decided weightage of each asset in a portfolio of different asset classes. It is one of the most important steps in portfolio management or PMS.

It can also be done if an individual’s financial situation has changed, which has resulted in a change of his / her risk appetite or investment strategy too. This includes an addition of a new financial goal or retirement, etc.

Let us first understand how portfolio rebalancing is done with the help of an example. Suppose Ms. A has decided to allocate 50% of her capital to equity markets and 50% to bonds.

At some point in time, stocks started performing really well, which resulted in a change of the ratio from 50:50 to 60:40 in stocks and bonds, respectively.

Now, portfolio rebalancing can be done by selling some of her stocks to maintain the originally decided ratio of 50:50. This helps in avoiding the extra exposure to one asset class.

Reasons For Portfolio Rebalancing

Let us try to understand the main reasons behind portfolio rebalancing now

1) Minimising Risk

Sometimes, due to the relatively good performance of one asset class, the number of funds allocated to that asset can be increased.

This leads to overexposure to that asset class-leading to riskier scenarios. Therefore, portfolio rebalancing is necessary for such situations to manage risk.

2) Capital Growth

While building a portfolio, everyone has some selection criteria. It is only after meeting these criteria; any investment is made in a financial instrument.

So, an important exercise to be done in portfolio rebalancing is to check whether all the assets are still meeting those criteria.

If some asset class does not fulfill the criteria anymore, funds should be withdrawn from that instrument and allocated to some other asset fulfilling the investment criteria.

Doing this exercise regularly ensures that capital growth happens at a faster pace as compared to being left as such after making the investment.

3) Saving on Taxes 

If portfolio rebalancing is done on a regular basis, it can help one in saving money on taxes. Also, if there has been some loss on one asset class, it can be used to offset profits earned through another asset class.

This is called tax-loss harvesting, which is an additional benefit of portfolio rebalancing. Having discussed all the benefits of portfolio rebalancing, let us now see how it can be done.

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Ways of Portfolio Rebalancing

There are many ways in which an individual can balance his / her portfolio. The way chosen by a person depends on the availability of time, knowledge, skill, and personal preference.

Let us discuss the different ways of portfolio rebalancing.

       1) Portfolio Rebalancing Using the Original Ratios

This is the most common method of portfolio rebalancing. In this, buying and selling of the assets are done to bring the weightage of different assets to the initially decided ratio.

This is done when more than originally decided capital was allocated to a particular over-performing asset for some time, which increased the overall risk of the portfolio.

This can be easily done by selling some assets and buying other ones in the desired proportions.

        2) Portfolio Rebalancing Using Current Trends

This is a dynamic approach to rebalancing a portfolio. The current trends are used for deciding the new positions that need to be taken in different asset classes.

For example, geopolitical tension in a country can lead to a rise in the prices of gold and silver. So, rebalancing can be done by reducing funds from one asset class and increasing them in gold and silver, etc.

       3) Portfolio Rebalancing Using A Rule

One can make some rules for adding or/and withdrawing funds from an asset if it reaches a certain limit. Also, one can change the number of funds allocated to fixed-rate debt and variable rate funds according to the current rate of interest.

       4) Portfolio Rebalancing Using a Professional 

This is one of the least time-consuming methods of portfolio rebalancing. One can hire a professional fund manager to check the current portfolio and make required amendments in it as per the needs of one’s financial goals.

One must be aware that if discretion is given to the manager, then decisions can be taken without your prior approvals. So, a trust factor needs to be there before using this method.

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Conclusion

Portfolio rebalancing is a very important step in the process of portfolio management. This involves changing the number of funds allocated to different assets to bring the current ratios to the originally planned ones.

Portfolio rebalancing is important because it protects investors against overexposure in a single asset. It minimizes the overall risk in a portfolio.

Also, regular rebalancing ensures capital growth at a decent rate. Another important benefit of portfolio rebalancing is tax saving and tax harvesting.

There are many ways in which portfolio rebalancing can be done.

The first one is the conventional way of adjusting the weights of funds in different assets to the original weights.

The second one is a more dynamic approach that changes with the current microeconomic and macroeconomic factors.

It helps in getting better returns on the capital employed. Another method is to use a rule to make changes in the fund allocated to different assets in a portfolio.

The last way of portfolio rebalancing is using the help of a professional fund manager who can make changes in your strategy using his discretion.

No matter which method you choose, it is important to do portfolio rebalancing to ensure better returns on your hard-earned capital.

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