Portfolio Rebalancing

Updated on April 4, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Portfolio Rebalancing?

Portfolio rebalancing is the process that helps investors restore the originally allocated assets per their weightage from time to time to meet the set financial goals. However, the financial requirements and the risks associated with trading keep changing. Thus, the portfolio allocation must be restored accordingly.

What Is Portfolio Rebalancing

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The value of the assets changes per the returns they generate. Accordingly, the weightage of the assets differs. Depending on the current weight of the assets, the investors require categorizing them under the portfolio labels best suited for the respective financial instruments per the investment plan. This, in turn, helps balance investor portfolios as per the changing market scenario.

Key Takeaways

  • Portfolio rebalancing is a reallocation of the weight of portfolio assets. It includes buying and selling existing assets either fully or partially from time to time to maintain the desired level of return.
  • Rebalancing can be industry or sector-specific or in combination.
  • The portfolio assets can be a mix of bonds, equity, and other stocks depending on the investor’s appetite for risk and return and movement and value of stocks.
  • Portfolio rebalancing can be time-based, threshold-based, or risk-based, depending on the investors’ approach and suitability.

Portfolio Rebalancing Explained

Portfolio rebalancing keeps investor profiles balanced. Given the frequent fluctuations in the market, individuals must have a provision for adjusting their portfolios to ensure minimum risks and maximum profits on any investment. In addition, the rebalancing process enables them to reallocate their assets, so the holders do not incur losses.

Rebalancing is done to ensure investors do not depend on the performance of a single investment. It gives investors a chance to have a diversified portfolio. The scattered investments make people control risks by not depending on the success or failure of a single portfolio.

The portfolio is rebalanced from time to time so that investors can gain maximum return on investment. Wealth managers, mutual funds providers, and investment bankers who handle portfolios involving a huge amount of money pay careful consideration to rebalance to deliver the expected return level throughout the investment tenure.

The investor or fund manager shuffles the stocks in the portfolio to maintain the desired return and risk level. This shuffling is done after careful stock analysis, facilitated by a lot of decision-making and experience. The portfolio is based on an investor’s risk appetite. For example, a risk-averse investor (low-risk taker) invests more in bonds than in equity. The reason is that bonds deliver fixed and periodic interest rates and volatile equity. In such a case, the investor might invest around 70%-80% in bonds and balance 30%-20% in equity.

Similarly, an investor who wants a high return and has a good risk appetite will invest less in bonds and more in inequity. In such a case, the scenario is reversed, and they invest 70%-80% in equity and the remaining 30%-20% in bonds. Again, an investor who wants an average return will invest 50% each in bonds and stocks.

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Strategies

Portfolio rebalancing lets investors gain higher returns and control the associated risks. But, first, money managers and investors need to implement effective portfolio rebalancing strategies to ensure the process works at its best. The practices that tend to be the most useful are either time-based, threshold-based, or risk-based.

Portfolio Rebalancing Strategies

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Time-based rebalancing refers to balancing portfolios at specific intervals based on status, as revealed through regular monitoring. Though it is an effective means of determining ways to rebalance, overdoing the same could hamper the returns. Thus, time-based rebalancing must be done carefully.

The threshold-based portfolio enables investors to reallocate asset classes to have a mixed or diverse portfolio. This, in turn, ensures individuals adopting the strategy reap maximum profits as they do not have to depend on a single investment. Instead, they can have diversified portfolios for profits and risk control.

The risk-based rebalancing lets investors rebalance portfolios if they realize the risks would increase. In short, they can choose to diversify their investments to tackle the losses wisely. Learning these practices makes investors understand the portfolio rebalancing meaning better.

Example

Let us consider the following portfolio rebalancing example to understand the concept better:

A Mutual funds manager pools in $10m from individual investors, and diversifies the risk in the portfolio by investing 50% in equity and 50% in bonds. The manager also diversifies risks further across different sectors in the percentage below.

Telecommunication10%
Real Estate10%
FMCG15%
Hospitality5%
Banking10%
Manufacturing5%
Oil and Gas15%
Pharmaceuticals20%
Information Technology10%

The fund manager chooses to review the performance regularly and decide to rebalance the portfolio monthly, quarterly, or yearly per the suitability.

Pros & Cons

The portfolio rebalancing tool serves to be of great help to investors as they can profit and hedge risks to a great extent. However, the process is not devoid of disadvantages. The benefits and challenges of it are as follows:

AdvantagesDisadvantages
Balances risks and returnsLeads to cutting off the performance leg of stocks.
Tracks and maintains financial returns and expectationsWrong decisions can lead to higher exposure to risk
Rebalancing habit helps to achieve the desired level of returnFrequent rebalancing leads to higher transaction costs.
Mitigates unwanted risksKnowledge and experience required

Tax Implications

Portfolio rebalancing follows a set of tax guidelines for investors to be aware of. These rebalancing portfolios remain tax exempted when the trade is taken. This process possibly leads to profits, hedging risks simultaneously. However, these profits are taxable, and investors are liable to pay them as applicable. Sometimes, this tax application makes investors reluctant to do portfolio rebalancing.

Frequently Asked Questions (FAQs)

How to do portfolio rebalancing?

Investors must have a thorough plan to determine how and where to invest for a diversified portfolio. They need to monitor the market and decide on the financial instruments that are likely to reap more profits and help cover unavoidable losses. As soon as the repercussions are known, the investors can decide on the portfolios to invest in for better returns.

Does portfolio rebalancing cost money?

Rebalancing can be done without costing investors any money. They can do it themselves. However, if they take the assistance of professional advisors, it would come in exchange for a fee or commission.

Does portfolio rebalancing improve returns?

Rebalancing a portfolio aims not to increase returns or profits but to control the risks. In short, when there are multiple investments, the profit from one can help bear the loss incurred from the other.

This has been a guide to What is Portfolio Rebalancing & its meaning. Here, we explain how it works with its pros and cons, taxation, and best practices. You can learn more about Asset Management from the following articles –

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