Portfolio Rebalancing: What is it, Why is it important and How to do it


What is portfolio rebalancing?

Portfolio rebalancing is the process of making changes in your existing portfolio so that it matches the currently recommended/desired portfolio for you.

It involves periodically selling and buying assets in a portfolio in order to keep the portfolio aligned to a strategy or risk level.

In simple terms, you sell what is over-weighted or not required anymore and re-invest the money in what needs to be added to in the portfolio (an under-weight or new investment).

In this process, no fresh money is added to the portfolio - only the money that is redeemed gets re-invested, hence the word rebalancing.


Why is portfolio rebalancing necessary?

A portfolio is generally made of investments made in different types of assets e.g. equity, debt etc.

Within each asset, we select the best investment available in that asset class according to some selection strategy (eg recommendations from an advisor, based on one's own rules etc).

E.g. Say, your portfolio of Rs 1 lakh consists of 50% equity and 50% debt.

Within equity the amount is spread equally across Funds A and B and within debt the amount is invested equally in Funds C and Funds D.

So overall, your portfolio looks like this:

  1. Fund A - Equity - Rs 25,000 - 25%
  2. Fund B - Equity - Rs 25,000 - 25%
  3. Fund C - Debt - Rs 25,000 - 25%
  4. Fund D - Debt - Rs 25,000 - 25%
    Total = 1,00,000

Over the next 5 years, assume your equity investments grow by 15% per annum and your debt investments grow by 7% per annum (both reasonable assumptions based on historical averages).

If you don't touch your portfolio then after 5 years, it will look like this:

  1. Fund A - Equity - Rs 25,000 *1.15^5 ~ Rs 50,000 ~ 30%
  2. Fund B - Equity - Rs 25,000 *1.15^5 ~ Rs 50,000 ~ 30%
  3. Fund C - Debt - Rs 25,000 *1.07^5 ~ Rs 35,000 ~ 20%
  4. Fund D - Debt - Rs 25,000 *1.07^5 ~ Rs 35,000 ~ 20%
    Total = 1,70,000

At the end of 5 years, your total equity exposure has increased to 60% while your debt exposure has decreased to 40% - a gap of 20% between them from 0% 5 years ago.

How does it look at the end of 10 years?

  1. Fund A - Equity - Rs 25,000 *1.15^10 ~ Rs 101,000 ~ 34%
  2. Fund B - Equity - Rs 25,000 *1.15^10 ~ Rs 101,000 ~ 34%
  3. Fund C - Debt - Rs 25,000 *1.07^10 ~ Rs 49,000 ~ 16%
  4. Fund D - Debt - Rs 25,000 *1.07^10 ~ Rs 49,000 ~ 16%
    Total = 3,00,000

At the end of 10 years, your total equity exposure has increased to close to 70% while your debt exposure has decreased further to about 30% - a gap of 40% between them!

equity-debt-1

At the end of 30 years, nearly your entire portfolio will be in equity and you will be completely exposed to the equity market risk (regardless of your actual risk profile).

So without rebalancing, even an initially equally allocated portfolio will drift towards overweighting the higher growth (and higher risk) asset as you age i.e. over time the risk in your portfolio will increase if you leave it untouched.

Over time the risk in your portfolio will increase if you don't rebalance.

This is the exact opposite of what you would generally want - as your grow older or reach closer to your goal, you would want risk to decrease, and not increase!

Apart from asset allocation drift, there is another very important reason for rebalancing especially if you are using actively managed funds to invest - you need to review your fund selection so that you are investing in only the best funds always.

Funds A, B, C and D may not be the best funds to invest in for all of the 10 years.

So, even though you may be investing for the long term, you are not going to invest in the same funds for your entire life. Some of today's best performing funds did not even exist 10 years ago. Hence you may need to update your fund selection periodically based on your Mutual Fund selection strategy.

So, in summary, portfolio rebalancing is mainly required for the following two reasons -

  1. to keep the risk of the portfolio in check by maintaining the desired asset allocation between risky and non-risky assets.

  2. to get rid of under-performing investments within an asset class and replace them with better performing investments (especially when using actively managed investments like Mutual Funds).


Benefits of portfolio rebalancing

Based on the above, there are three benefits of portfolio rebalancing:

1. Manage risk

As we discussed above, an untouched portfolio will become riskier over time as the proportion of high-growth high-risk assets increase.

In order to maintain the same level of risk, we need to sell some of the investments in the over-weighted asset class (eg equity) and re-invest the proceeds in the under-weighted asset class (eg debt).

Better still, if we want to reduce the risk of our investments over time as we age or as we near our goal, we need to follow a glide path of decreasing equity asset allocation which can be done via periodic rebalancing.

2. Improve returns

When using actively managed funds to invest, one must regularly assess the performance of the funds in our portfolio. If they no longer meet our selection criteria they need to be booted out and replaced by those that do. Doing this regularly will ensure that we are constantly in sync with our selection strategy and earn superior returns.

3. [Advanced] Save taxes via tax harvesting

Regular portfolio rebalancing can help you save taxes depending on the prevalent taxation rules.

For e.g. currently there is a tax of 10% on Long Term Capital Gains for equity investments. However, LTCG of up to 1 lakh are exempt from this tax and only the LTCG amount above Rs 1 lakh will be taxed at 10% in a financial year.

This provides an opportunity to keep booking upto 1 lakh of gains under LTCG every year without paying any tax (and re-investing) which otherwise could have resulted in a hefty tax bill later (tax gain harvesting).

Similarly, a capital loss from one investment or asset may be used to offset gains from another during the rebalancing process (tax loss harvesting).

benfits-of-portfolio-rebalancing

What are the costs of portfolio rebalancing

Since portfolio rebalancing requires selling and buying investments, there are some costs associated with it:

1. Transaction costs

Depending on who you transact with, there could be transaction costs levied by your investment service provider for each buy or sell transaction.

2. Exit load

Certain investments like Mutual Funds etc have an exit load rule where they charge a small penalty if you redeem your investments before a specified time period e.g. Equity Mutual Funds generally charge an exit load of 1% if you redeem your money within an year.

A good practice is to rebalance only those parts of your investments that have become exit load free so that you don't incur any un-necessary penalty while rebalancing.

3. Taxes

Since rebalancing involves selling some of your investments, it involves incurring capital gains and hence capital gains tax liability.

Taxation of differet asset classes is different (read more about capital gains taxation for Mutual Funds here) and generally the best practice is to rebalance only the least taxable parts of your portfolio e.g. those that qualify for long term capital gains.

However, if it comes to choosing between lowering risk vs saving tax, it is generally recommended to reduce risk in your portfolio over avoiding some tax.


How often should you rebalance your portfolio?

Portfolio rebalancing frequency should be decided according to your fund selection strategy as it is futile to review your investments over very short time periods. It should also take into account, typical exit load period and taxation rules governing classification of gains into short term and long term.

For Mutual Funds in India, a good rebalancing frequency is 1 year since that coincides with the typical exit load period and long term capital gains period. If you have a cost efficient rebalancing process i.e. which excludes investments under exit load and minimises tax incidence, you can rebalance at a 6-month frequency as well.


How to do portfolio rebalancing

Step 1. List all the investments in your existing portfolio along with the asset class of each investment.

Step 2. Write down your target portfolio which has your desired investment allocation. This could be done on the basis of your risk profile, financial plan and your fund selection strategy. Basically, this is the portfolio that you want to have today. If you are not sure, talk to a financial advisor at Goalwise.

Step 3. Take the difference of the two portfolios (target - current). This will give you a list of redeem and re-invest transactions that you need to do in order to fully rebalance your portfolio (i.e. without taking any exit load or taxation into account).

Step 4. Adjust the redemption transactions to redeem only exit load free amount or tax-free/tax-optimised amount into account. Here are some pointers on how to do that:
a) Avoid rebalancing equity investments before 1 year to avoid exit load and short term capital gains tax.
b) Avoid moving money from one debt fund to another debt fund since there is not much difference between them and you will end up incurring capital gains tax.

Step 5. Adjust the re-investment transactions so that total re-investment amount matches the total redemption amount.

Step 6. Execute the redemption transactions. Wait for the money to come in and then execute the re-investment transactions. (If your investment platform allows you to place the two set of transactions simultaneously, then that's better).

Step 7. Review your portfolio once every 6 months or as recommended by your financal advisor.


Portfolio rebalancing example from Goalwise

Goalwise is a leading goal-based investing platform which provides an automated portfolio rebalancing feature to its investors (like me).

Here is an example of one of my goals that needed rebalancing.

This was the current portfolio:

Current Portfolio

This was the target portfolio which was automatically computed according to my existing goal plan:

Target Portfolio

And based on these, Goalwise computed the amount and transactions that I could rebalance without incurring any exit load or taxes. No computations needed to be done by me.

Portfolio Rebalance Transactions

After reviewing the transactions I just had to click confirm and the rebalancing transactions would be generated and queued for execution. That's it!

Portfolio rebalancing is the secret sauce of successful long term investing. It requires you to have an investment strategy and an asset allocation framework. If done periodically, it will keep you on-track to achieving your financial goals.

invest-with-goalwise-cta