Portfolio Rebalancing – What Is It and Why You Should Do It?

Rebalancing is the process by which an investor restores their portfolio to its target allocation. Rebalancing brings your portfolio back to the desired asset mix. This is done by divesting in underperforming assets and investing in the ones that have the potential to grow. 

Why is Rebalancing important for you?

The primary objective of portfolio rebalancing is to establish better risk control, and ensure that your portfolio isn’t singularly dependent on the success or failure of a particular investment, asset class, or fund type.

Example: Let’s assume that you invested Rs 10,000 in mutual fund A and Rs 10,000 in mutual fund B in January 2018. At the end of one year, your investment of Rs 20,000 doubles up and turns into a dividend of Rs 41,000. Due to market forces, it may happen that both the funds may not perform equally. So, while fund A gives you Rs 17,000 at the end of the year, fund B returns Rs, 24,000. When you began your investment, both the funds had the same weight. At the end of 1 year, one fund dominated your portfolio with a roughly 60% share. If in the coming years this fund were to perform badly, then your investments would see a downward turn in no time at all!

How can rebalancing help you as an investor?

Rebalancing works as a risk-minimising strategy for you as an investor. It allows you to line up your investment with your goals by periodically rebalancing your portfolio. If your risk tolerance or your investment strategies change, then you can rebalance the weight of the asset class in your portfolio by reassessing and devising a new asset allocation.

How can you rebalance your portfolio?

When you invest in mutual funds, you are investing to achieve a single goal via various vehicles. So when you rebalance, the shift must occur across all of these funds at the same time. Here’s how you can rebalance your portfolio in 5 simple steps: 

Step 1: Primarily, have an asset allocation plan by considering your income, the expected time of retirement, and so on. Create an asset allocation framework, but if you are unsure speak to an expert – ClearTax can be of help here. 

Step 2: Assess your current asset allocation by identifying where and how your current investments are placed in stocks, cash, bonds, or any other form of investment. After this, make a comparative analysis of asset allocation target and its present state and make adjustments accordingly.

Step 3:Chart out a rebalancing plan is your asset allocation target does not align with your current portfolio. This step can be tricky where you have to decide on the securities to retain and in what numbers. Speak to our experts at ClearTax to get clarity. 

Step 4: Be mindful of the tax implications, especially on capital gains. Avoid the short term taxes on capital gains by holding on to your equities for over a year. In the case of debt funds, the short-term capital gains will qualify for taxes based on the individuals’ income tax slab. For long-term capital gains, the tax is 20% with indexation. If you need to scale back, aim to sell the securities in the tax-exempt accounts first. In this way, you can limit the taxes you pay in capital gains. 

Step 5: Review your portfolio at least once a year or maybe once in six months to assess your position but rebalance it only when you feel that the allocations are significantly out of the track to reaching the target.  

What is the cost involved with Rebalancing your Portfolio?

There are certain expenses involved with rebalancing your portfolio, and as an investor, you must be aware of the following:

• The cost of brokerage and Securities Transaction Tax (STT) is one of the expenses you will incur as an investor. This includes the transaction cost of buying and selling securities like stocks and bonds.
• Charges of exit load of about 2% in the case of mutual funds can be levied if you sell your investment within a specific period.
• You will incur taxation on capital gains on the sale of equity investments within a year. There will be a marginal tax rate for debt investments that you sell within three years.

Rebalancing of a portfolio is more about identifying and implementing a system that works best for you as an investor. It must never be about merely adopting what works well for someone else. At the same time, it also entails reviewing and making informed adjustments, keeping in mind the tax and other consequences.

If you seek further assistance in rebalancing your portfolio, then get in touch with us at ClearTax to know more.   

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