The author is CEO of PaisabazaarFor many salaried individuals, the new financial year starts with big salaries and bonuses. With higher income, the immediate instinct may be to invest in a new mutual fund scheme, increase SIP contributions or explore other investment avenues; But, it also presents a great opportunity to review and rebalance your current investment portfolio. After all, your risk tolerance, financial goals, and tax strategies may have changed over the past year. Therefore, it would be wise to make sure that your portfolio is still where you want it.
Why does the portfolio need to be reviewed from time to time?
When building an investment portfolio, investors decide on asset allocation. Suppose, a portfolio consisting of 70% equity and 30% debt investments. This allocation should be a well-thought-out decision that an investor should make after considering his age, financial goals, income, risk tolerance, etc. Now, an asset class usually generates different returns over a period of time. This differential performance across asset classes causes the asset mix to deviate from its original or initial allocation. Therefore, the portfolio that started as 70:30 may change to 80:20 in favor of higher equity exposure to meet financial goals.In other words, the asset mix may differ from one’s risk and return objectives and may affect the achievement of investment goals. This is where you need to rebalance your investment portfolio. Portfolio rebalancing is an exercise for investors to ensure that their investment portfolio remains in line with their financial goals and risk appetite. This helps investors:
- Align their investment portfolio with their financial goals and risk appetite.
- Prevent any one high-performing stock or sector from dominating the entire portfolio.
- Reduce overvalued assets and reinvest in areas that are expected to grow significantly.
How should you rebalance your investment portfolio?
Investors can rebalance their investment portfolio by following the following process:Review your financial goals and risk appetiteLike the stock market, life is always in a state of constant flux. Therefore, reviewing your current situation, such as your financial goals, is essential to calibrate investment allocations and ensure that your financial roadmap keeps pace with unexpected life changes or market shifts. You also need to reevaluate your risk tolerance as it may change over time. For example, a young investor with no dependents and no financial liabilities may be more comfortable investing a larger portion of his income in equities than someone reaching a major financial goal or approaching retirement.
Rebalancing a Portfolio – 6 Simple Steps
Know your target allocationOnce you have reviewed and revised your financial goals, set a target allocation because without this you will not know where you are rebalancing. Your target allocation should reflect your current situation. Therefore, when determining what percentage should be in stocks, gold, real estate and other asset classes, consider your remaining service years, income, financial goals, risk appetite and other influencing factors.Compare current allocation with target allocationNow that you’ve determined your optimal target allocation, it’s time to look at your current asset allocation. For this, calculate the present value of each asset class (e.g. equity, debt, gold, real estate, etc.) and note down each category as a percentage of your total investment portfolio. Next, compare your current asset allocation with your target allocation to see where you need to add or remove assets to restore your portfolio to its target level.Decide what to add, cut or leave outIf the asset mix in your portfolio matches your target asset allocation, you don’t need a plan. However, if an asset allocation deviates more than a predetermined threshold, such as five percentage points, you will need to make the necessary changes.
- Add new funds or top up existing funds where the allocation is low.
- Stop new investment where allocation is excess. In such overweight asset classes, you can also redeem a small portion if necessary.
- Switch but only when necessary. Replacing one investment with another can be considered only when your portfolio has deviated significantly from your target allocation or when an existing fund no longer meets your investment objectives due to consistent poor performance or a change in its strategy.
- Pay attention to how different holdings affect your style-box positioning and sector weightings. Your stock portfolio doesn’t need to be an exact clone of the broader market, but you should at least be aware of whether your portfolio is leaning too heavily toward any one style or sector.
Look beyond individual fund performanceA common mistake made by investors is that they change mutual funds simply because they have performed poorly in the short term. Every investment category experiences cycles of outperformance and underperformance. Instead of reacting to recent returns, evaluate whether each fund serves a clear purpose within your portfolio.Avoid holding multiple funds with similar portfolio just because they have delivered strong returns recently. Excessive overlap reduces the benefits of diversification without necessarily improving results.Review fund performanceA common mistake made by investors is that they change mutual funds simply because they have performed poorly in the short term. Every investment category experiences cycles of outperformance and underperformance. Rather than reacting to recent returns, evaluate whether a fund has consistently created value throughout the market cycle while following its stated investment strategy.Compare its performance over the long term with its benchmark and peers, but don’t rely solely on returns. Consider factors such as stability in different market environments, risk-adjusted performance, protection from downside during market corrections, portfolio quality and whether the fund manager has been disciplined in executing the investment strategy. If a fund has consistently underperformed its benchmark and peers over multiple market cycles without any apparent justification, this may be indicative of a structural problem and may require replacement during the rebalancing process.Consider Taxes and Exit CostsRebalancing often involves selling investments, which may be subject to capital gains taxes depending on the holding period and applicable tax rules. These costs should be evaluated before making changes. In some cases, using new investments to restore the desired asset allocation may prove more efficient than immediately selling existing holdings.
How often should you rebalance your investment portfolio?
There is no set rule for how often you should rebalance your investment portfolio. If you have been investing for say 6 months or 18 months, rebalancing would not make sense as your portfolio would still need to experience one phase of the market cycle to see how it performs under current market conditions. For those who have had their portfolio for more than 2 years, a portfolio review is usually recommended every 12 months.
When should you rebalance your portfolio?
Over the long term, the portfolio usually requires periodic review from both an allocation and performance perspective. Over time, as life-stages, risk appetite and goals change, your portfolio may need some adjustment. For example, with some life-goal like your child’s higher education approaching, you may need to shift the money parked for goals from equities to fixed income instruments for capital protection and to avoid market volatility when you need to cash out.Similarly, when your asset allocation deviates from your target or preferred asset allocation by more than 5%-10% points or when a single sector or stock throws your entire portfolio out of your risk tolerance.Common Mistakes to Avoid in RebalancingHere are some common mistakes investors should avoid when rebalancing their investment portfolio:Rebalancing frequently: Rebalancing your portfolio frequently, i.e. every week or month, can lead to unnecessary transaction costs, exit loads and tax implications without providing real benefits. Thus, give your investments some room to grow before intervening.
Rebalancing a portfolio: 5 mistakes to avoid
Emotional Decision Making: Selling your best holdings is one of the hardest decisions you can make when rebalancing. It may seem wrong to sell when equities are at all-time highs. When they’re falling, buying more can seem scary. Financial discipline and a clear, long-term plan should remain the guiding principles through market cycles.Ignoring the whole picture: Many investors rebalance only one account while forgetting about the others. Your investment portfolio includes everything across every investment account and platform. Therefore, always look at the bigger and bigger picture before taking investment decisions.Not reviewing your portfolio: Rebalancing your portfolio is a recurring practice as over time, you experience increases in your income, changes in your goals, and changes in risk tolerance. You should re-review your investment portfolio every few years to ensure that your portfolio is in line with these changes.
