Portfolio Rebalancing Guide: Why it’s Crucial for Long-Term Success in India?

In an evolving market, the investment strategies that were successful yesterday may not be effective today. Hence, investing in financial markets is not a one-time event. You need to regularly check your portfolio to see if it is optimised for current market dynamics. Portfolio rebalancing is one strategy that investors use to keep their investments aligned with the market.

This blog will serve as a comprehensive portfolio rebalancing guide to help you keep up with the changing aspects of the market.

What is Portfolio Rebalancing?

Portfolio rebalancing refers to adjusting the proportions of assets to restore each asset class’s weight to its original state. Over time, due to market fluctuations, the asset allocation in a portfolio may drift away from the investor’s original plan. Rebalancing helps restore the desired allocation by buying or selling assets accordingly.

For example, you initially allocated 60% of your portfolio to equities and 40% to debt instruments. However, due to market fluctuations, equities now make up 70% of the portfolio, and the remaining 30% is debt. To restore the original 60:40 ratio, you would need to sell some equities and purchase debt instruments.

Importance of Portfolio Rebalancing

Here is why you should do portfolio rebalancing:

• Preserving Risk Tolerance – Every investor has a specific risk tolerance. A stagnant portfolio would become riskier or more conservative, leading to potential losses or missed opportunities.
• Enhancing Long-Term Returns – You can periodically rebalance your portfolio by taking profits from high-performing assets and reinvesting in upcoming potential assets. This practice aligns with the “buy low, sell high” strategy.
• Adopting New Strategies – Portfolio rebalancing also helps you implement new investment strategies, keeping pace with the evolving market and investment goals.

When to Rebalance Portfolio?

Ideally, portfolio rebalancing is triggered under the following conditions:

• Fixed Interval– Portfolio rebalancing can be done at fixed intervals, such as quarterly, semi-annually, or annually. If the markets are highly volatile, rebalancing needs to be done more frequently.
• Fixed Allocation– Rebalancing can be done when a portfolio’s asset allocation deviates beyond set thresholds (e.g., 5% or 10%), ensuring it stays aligned with its target risk and return profile.
• Combination of Fixed Interval and Fixed Allocation- Investors can combine both approaches, checking their portfolios at set intervals and rebalancing only if asset allocations have deviated beyond a predefined range.

Strategies for Portfolio Rebalancing

A portfolio rebalancing strategy must reflect the shift in financial realities and risk profile and the changing market dynamics regarding assets. It should be based on the following factors:

• Original Allocation

This rebalancing method helps to automatically monetise profits. In an ideal situation, an allocation ratio of 60:30:10 for equity, debt, and liquid funds is maintained, with a +/- 5% range. When the 5% mark is breached for any components, the portfolio is rebalanced to return to the original master allocation. 

• Emerging Trends

This approach is slightly more dynamic as it is based on the key emerging trends in the market. For example, increasing interest rates may make long-term bonds vulnerable, and the portfolio may require rebalancing. Again, during a market downturn, equities may be available at historically low prices, which might call for rebalancing. 

• Rule-based Proposition

A rule can be set to reduce equity allocation by 5%  if the equity valuation exceeds 18 P/E. If it crosses 22 P/E, the allocation is reduced by another 5%. Also, you can set a rule to shift between fixed and variable rates depending on how much the interest rates have differed from the mean.

• Managerial Discretion

Fund managers can shift asset allocation between equity and debt based on the market outlook. However, this is an aggressive strategy that relies heavily on the manager’s judgment and potential bias. To automate this process, investors can choose a dynamic mutual fund.

• Tax Efficiency

In this approach, the portfolio is rebalanced to make it more tax-efficient. For instance, with the falling yields on small savings like PPF, an investor will want to shift to long-term risk assets like ELSS for saving tax under Section 80C.

Portfolio Rebalancing in a Bear Market

A common concern is whether it is a good idea to rebalance the portfolio during a bearish market. The answer depends on specific conditions, but here are some key tips:

• Stick to Strategy: If your rebalancing is well planned, market downturns should not deter you from following it.
• Buy Low, Sell High: Bear markets provide an opportunity to buy undervalued assets at a discount and sell them when their value appreciates.
• Evaluate Market Conditions: In case of an extremely low level or market crash, investors should be more cautious to preserve capital.
• Ensure Liquidity: If cash flow is a concern, the rebalancing strategy should not lead to unnecessary liquidity issues.

How Does Portfolio Rebalancing Affect Taxes?

Portfolio rebalancing can lead to various tax implications. Here are some ways to minimise tax burden:

• Use Tax-Advantaged Accounts: Rebalancing in tax-advantaged accounts like PPF, NPS, or EPF prevents capital gains taxes.
• Prioritise Tax-Efficient Investments: Index funds and ETFs tend to be more tax-efficient than actively managed funds.
• Utilise Tax Loss Harvesting: Selling losing investments to offset gains can help minimise taxable income.
• Strategic Asset Placement: Holding tax-inefficient investments in tax-advantaged accounts can reduce overall tax liabilities.

Conclusion

Portfolio rebalancing is a crucial component for long-term portfolio appreciation. By maintaining the right asset allocation, investors can manage risk, optimise returns, and avoid emotional decision-making.  A more practical approach would be working with a trusted broker who can help you rebalance your portfolio using all the right techniques. If you’re looking for expert guidance in investments, Torus Digital is here to help!