Portfolio Rebalancing Guide: The Blueprint for Financial Success

Building wealth requires active management of your investments. A powerful tool for savvy investors is portfolio rebalancing. This strategy can significantly impact your investment journey by helping you achieve consistent and desirable returns (CAGR) over the long term.

While mutual funds offer diversification and ease of access to the market, simply choosing funds isn’t enough. Market movements can alter your portfolio’s asset allocation, potentially enabling you to take unintended risks. Portfolio rebalancing helps address this by ensuring your investments stay aligned with your financial goals.

In this article, we’ll unravel the mysteries behind MF portfolio rebalancing, answering burning questions and shedding light on some of the best practices.

Table of Contents:

1) Why is rebalancing required?
2) When you should Rebalance?
3) How often should you Rebalance?
4) Does Portfolio Rebalancing Improve Returns?
5) Conclusion

1.)Why is Rebalancing required?

Imagine your investment portfolio is like a recipe, with different ingredients representing various assets like stocks, bonds, or other securities. Over time, due to market fluctuations, some ingredients may become more prominent (or less) than you initially planned.

Portfolio rebalancing is the process of bringing back your portfolio to its original mix or adjusting it according to your desired asset allocation. It’s like tweaking the recipe to maintain the right balance of risk and return based on your investment strategy.

Here’s a quick example: Let’s say you initially decided on a 70% stocks and 30% bonds mix. Over time, if the stock market performs exceptionally well, your stocks’ value might increase, making up, let’s say, 80% of your portfolio. To rebalance, you’d sell some stocks and buy more bonds to get back to that 70/30 split.

The main goal of portfolio rebalancing is to manage risk. Markets can be unpredictable, and if one asset class becomes too dominant, it could expose you to more risk than you’re comfortable handling. By rebalancing, you’re essentially staying on course with your original investment plan.

To know more about the benefits of Portfolio Rebalancing we would recommend you to watch our video on:

Now, the next dilemma would be when is the optimum time to rebalance your investment portfolio.

2.)When you should Rebalance?

As you engage in mutual fund investments, a question naturally emerges: when is the optimal time for rebalancing? Identifying the triggers for rebalancing becomes essential. Let’s delve into this query and uncover the precise cues that warrant portfolio rebalancing, ensuring your investment strategy remains aligned with your financial goals.

We will broadly classify the 2 categories based on our profile and the current market scenario

• Individual Outcomes: Financial Milestones, change in Risk tolerances, and Life Events
• Changing Macro Economics

Individual Outcomes

• Financial Milestones:

It’s really important to adjust your mutual fund investments when you’re getting close to reaching your money goal. As you get near the target, it’s a good idea to regularly check and change your investment mix. This means making sure that the way you distribute your money in different types of investments matches how much risk you’re comfortable with and what you need to achieve your goal.

A smart move is to shift some of your money from more risky investments like stocks to safer ones like bonds. This helps you preserve your wealth and keeps your investment plan in good shape. Taking this active approach lets you fine-tune your investments, making necessary changes to keep a well-balanced and optimized portfolio as you get closer to reaching your financial goal.

• Life Events:

Life is like a journey with important checkpoints, and each of these can affect how you manage your money. Whether it’s starting a new job, getting married, or buying a home, these moments can mean you need to change how you handle your investments. Take a good look at your money plan to make sure it still matches what you want to achieve financially. For example, having a new family member might mean you want to move some of your money into safer and more reliable investments.

• Change in Risk appetite:

We may encounter sudden risk appetite changes during the investment journey. These risk changes may be both upward and downward and may impact our future investments. If you believe that the risk appetite increases, you might be more inclined to seek higher returns.

In this scenario, the portfolio may be rebalanced by increasing exposure to equities, which generally carry higher risk but also the potential for higher returns.

On the other hand, if there’s a decrease in risk appetite, the focus may shift towards preserving capital and reducing volatility. Rebalancing could involve moving funds from equities to more stable assets like fixed income or cash, aiming for a more conservative investment approach.

Macro Economic Changes

As the stock market experiences fluctuations, the value of our investments also fluctuates. Recalibrating our investments is akin to ensuring we stay on the right path to achieve our goal of growing our money over time. This proactive adjustment to the changing market conditions aids in navigating uncertainties and progressing toward our significant financial aspirations. Now, let’s explore some major economic changes that can impact our investment strategy.

• Responding to Market Corrections:

When certain sectors or asset classes outperform or underperform, rebalancing allows you to reallocate your funds accordingly. If one part of your portfolio grows significantly, you might sell some of those assets and reinvest in areas that may have temporarily declined in value.

This proactive adjustment is crucial for maintaining a portfolio that aligns with your risk tolerance, financial assets, and market conditions. It is not about predicting the market’s next move but rather adapting your investments to the present reality. In doing so, you enhance the overall stability of your portfolio, making it more resilient to the inevitable shifts in the financial landscape.

• Changing Market Valuations:

Adjusting your investment plan when markets are either too expensive or too cheap is like making a smart move to match what’s happening in the market. When things are too expensive (based on the Nifty P/E, Nifty P/B, Market Cap to GDP, etc), it means stock prices are higher than they should be based on how well companies are doing. So, you might consider reducing how much money you have in stock to lower the risk.

On the flip side, when things are too cheap (undervalued), it means stock prices are lower than they should be. In this case, you might think about putting more money into stocks to potentially make more money when prices go up. This way, you’re being smart about your investments, trying to get the most out of what the market is doing at different times…

Having discussed the instances when portfolio rebalancing is necessary, the next logical inquiry emerges: How frequently should this be undertaken? Let’s delve into that in the following section.

To help you get a glimpse of the subject we recommend you to watch our video on:

3.)How often should you Rebalance?

In a recent research paper, The Vanguard team explored three common methods used by investors, advisors, and asset managers in the US markets for rebalancing portfolios and arrived at the different triggers under which the rebalancing ought to be done.

Though there are some fundamental differences in the volatility, market caps, etc it, is safer to employ the same triggers for Indian markets as well, at least for the sake of rebalancing.

• Calendar-based Trigger: This approach includes choosing how often to adjust your portfolio to match the desired mix of investments. The more frequent the adjustments, the less likely your actual mix will deviate from the target, but this may lead to higher costs, particularly if you don’t have extra funds available to help with the adjustments.

The tax portion may also go for a toss on account of the capital gains.

• Threshold-based Trigger: This strategy triggers rebalancing when the portfolio deviates by a specific percentage from the target allocation. However, a significant drawback is the need for daily monitoring, making it impractical for most investors. A smaller threshold reduces tracking error but increases transaction costs.
• Combined Calendar and Threshold-based Rebalancing: This approach integrates both calendar-based and threshold-based methods. The portfolio is rebalanced at set intervals based on the calendar, but adjustments are made if the deviation from the target allocation exceeds a specific percentage.

In simpler terms, investors can choose to rebalance their portfolios based on a schedule (like annually), or they can set a percentage threshold such as +- 5%. Some prefer a combination of both, ensuring a periodic review while allowing adjustments when the portfolio deviates significantly from its intended allocation.

Each method has its pros and cons, and the choice depends on individual preferences, monitoring capabilities, and the desired balance between tracking errors and transaction costs.

Source: Vanguard

The above chart shows that the under-the-calendar threshold-based triggers less frequent rebalancing and a threshold of 5% gives us the optimum and the most efficient strategy in rebalancing our portfolio considering the transaction costs and the taxes involved.

4.)Does Portfolio Rebalancing Improve Returns?

That is the million-dollar question. Though there are no direct answers for this, we shall try to decode this with the simple example of portfolio rebalancing under the calendar and threshold trigger that we had seen in the last section.

Before you read further, here is a short video to help you get a glimpse of the subject.

Rebalance 1: Seizing Opportunities During Market Volatility

Imagine you had diligently maintained a 60:40 ratio in your portfolio in February 2020. However, as the stock market sharply declined to 8K levels in March, the value of your investments likely followed suit, causing your desired equity allocation to drop to around 45%. As this is a huge dent which is much more than the 5% threshold, we decided to buy in more equity to bring it back to the 60:40 split.

By rebalancing your portfolio and restoring the equity-debt mix to the original 60-40%, you essentially capitalize on the market dip. This proactive approach not only allows you to engage in bottom fishing, acquiring assets at lower prices but also ensures that you remain actively involved in the market, thereby mitigating risk and potentially enhancing your investment outcomes.

Rebalancing 2 – Nov-Dec 2022: Navigating the Bull Run Peaks

Fast forward to November-December 2022, and the once-vibrant bull run that began in March 2020 is showing signs of slowing down. As a result of this sustained upward momentum, your equity investments may have experienced substantial growth, leading to a skewed asset mix, perhaps around 75:25 in favor of equities. This also coincides with the planned annual rebalancing as per your calendar.

Enter the same strategic move – rebalancing. This involves a calculated process of selling certain portions of your equity holdings and reallocating those funds into more stable instruments such as debt funds or bonds.

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A Comprehensive Guide to Different Types and Categories of Mutual Funds in India

We take for instance the nifty 10-year benchmark GSEC index values which can be a good proxy for the bonds as the bond index price. This index hovered around 2080 in Dec 2022 when we had rebalanced. So, post this period the GSEC index gave a run up by about 10% in the next 1 year, surpassing the nifty CAGR in the same period. Yet again, our rebalancing helped us stay above the average returns generated in the market.

Though the above 2 scenarios may not always work in the future, the rebalancing helps us achieve a bit more than what we could have achieved without the portfolio rebalance.

5.)Conclusion:

In summary, portfolio rebalancing serves as a dynamic and strategic tool crucial for navigating the ever-changing financial markets. Whether seizing opportunities in market downturns or securing gains during bullish phases, the practice ensures that an investor’s portfolio aligns with their risk tolerance and financial goals.

These scenarios underscore the proactive essence of rebalancing, turning market fluctuations into chances for optimization. The key takeaway emphasizes the importance of periodic reassessment, enabling investors to adjust their asset allocation and uphold a resilient, well-balanced investment portfolio.

As financial landscapes evolve, the prudent use of rebalancing remains fundamental for achieving consistent, risk-adjusted returns in the long run.

Happy Investing