Previously we discussed what is the net asset value. Now we will discuss what is rebalancing? And its importance
Over time, your portfolio might not align with your investment or savings objective because of the volatility in the market.
Sometimes, some asset classes may outperform the other asset classes in your portfolio and vice versa. So, accordingly, you need to rebalance your portfolio.
What is Rebalancing?
Rebalancing a portfolio means changing the weightage of assets in your portfolio holdings.
It is not necessary or compulsory to change your portfolio allocation. Not taking any call for rebalancing is also the process of rebalancing.
In simple words, let’s say if you are holding equity as 50% and debt as 50% in your portfolio, as per the market conditions, and financial goal, and considering other factors, you may not require changing the allocation.
You may require doing a frequent review of your portfolio but may not require rebalancing. Keeping track of your portfolio and rebalancing it whenever required is essential.
For example, suppose you want to accumulate Rs 1 Crore for your daughter’s higher education over 15 years, so you need to start with a SIP Amount of Rs 17,018/- per month.
| Target Amount for Education | ₹ 1,00,00,000 |
| Investment Horizon | 15 Years |
| Risk | High |
| SIP Amount | ₹ 17,018 |
| Actual Wealth Accumulated | ₹ 1,00,00,153 |
| Portfolio XIRR | 14.57% |
Let’s see how your portfolio has grown over time, even in turbulent times, if you were doing portfolio rebalancing. We will see in comparison with BSE Sensex as a Benchmark.
Source: BSE Sensex
By looking at the above graphical presentation, you can see that the portfolio has been rebalanced from time to time. All the arrows represent when the rebalancing has been done. Here, we did not try to time the market.
If you look at the period from January 2019 to December 2021, the portfolio’s volatility is reducing. To understand this better, look at the March 2020 crash period.
BSE Sensex has been down by almost -29% from its recent pick in Dec ’19, whereas the portfolio is down by almost 5% only because rebalancing in the portfolio is being done continuously.
When you do goal-based investing, the idea is to achieve the goal with optimized risk instead of running out of cash. The above portfolio has been rebalanced to reduce the risk when you are close to your target; the risk comes down to low risk from the high-risk category.
In the end, the capital should be preserved because, in a pre-defined event like child education, child wedding, retirement, etc we cannot delay it, but we can preserve our capital gains by shifting them to a safer asset class.
The below table shows how the risk in the portfolio has been reduced.
| Investment period | No of years | Risk |
| 0 -11 years | 11 years | High |
| 12 years | 1 year | Above average |
| 13 years | 1 year | Average |
| 14 years | 1 year | Below average |
| 15 years | 1 year | Low |
Now, you may say that if you remain invested without rebalancing your portfolio, you could have achieved your target because the market has recovered after that crash. Yes, you are right, but that would be with a very high risk.
Let’s assume a situation where the market did not recover after the crash. Then, you will not be able to fund your daughter’s education.
So basically, you derailed from the entire goal. The time and money you have invested for the past 15 years come down to zero. Because that downside risk is very high, you cannot push that pre-defined event/goal.
Conclusion:
Rebalancing the portfolio is critically essential. In a pre-defined event/goal, you cannot delay it. But with the help of rebalancing, you can achieve it even if the market crashes.
So, consider rebalancing a crucial part of your portfolio.
FAQs
What is the rebalancing investment strategy?
Rebalancing is an investment strategy that involves adjusting the portfolio’s asset allocation back to its original target or desired level.
It’s done periodically, typically annually or semi-annually, to maintain the desired risk level and take advantage of market fluctuations. This ensures the portfolio remains in line with the investor’s long-term objectives.
What is the 5/25 rule for rebalancing?
The 5/25 rule is a guideline for portfolio rebalancing, suggesting that investors should consider rebalancing their portfolio if an asset’s allocation deviates by more than 5% from the target allocation (5% threshold) or every 25% change in the portfolio’s overall value (25% rule).
What are the types of rebalancing strategies?
There are three main types of rebalancing strategies:
- Time-based rebalancing: Adjusting the portfolio at fixed intervals, like annually or quarterly.
- Rebalancing when the asset allocation departs from the target by a specific proportion is known as threshold-based rebalancing.
- Opportunistic rebalancing: Rebalancing when significant market events create deviations from the target allocation.
