Mutual Fund And Portfolio Rebalancing When, Why And How Should You Do It

Mutual funds are popular investment options that allow investors to pool their money together and invest in a diversified portfolio of securities, such as stocks, bonds, or a combination of both. However, managing a mutual fund portfolio requires periodic review and adjustments to ensure it remains in line with your investment objectives and risk tolerance.

Portfolio rebalancing is the process of readjusting the weights of various assets within a portfolio to maintain the desired asset allocation. In this article, we will explore when, why, and how to rebalance a mutual fund portfolio to potentially avail yourself of better investment returns and manage risk effectively.

• Table of contents

1. What is portfolio rebalancing?
2. How does portfolio rebalancing work?
3. When to consider mutual fund portfolio rebalancing?
4. Why rebalance a mutual fund portfolio?
5. Benefits of portfolio rebalancing during volatile markets
6. How to rebalance a mutual fund portfolio?

What is portfolio rebalancing?

Portfolio rebalancing involves adjusting your investment portfolio periodically to return to your target asset allocation. Market fluctuations can cause deviations, and rebalancing ensures your portfolio stays aligned with your goals. Rebalancing prevents unintended increases in risk by aligning with your target allocation. It helps keep your portfolio aligned with your financial goals while managing risk effectively.

How does portfolio rebalancing work?

Here's how portfolio rebalancing works, with an example to help you understand the process:

1. Define your target asset allocation
Decide your ideal mix of asset classes based on your risk tolerance, goals, and time horizon.
Example: A 60% equity (stocks) and 40% debt (bonds) allocation.

2. Build your initial portfolio
Invest according to your target allocation.
Example: Rs 60,000 in equity mutual funds and ₹40,000 in debt mutual funds, totaling Rs 100,000.

3. Monitor your portfolio
Track the performance of your investments over time.
Example: After one year, equity grows to Rs 75,000 and debt to Rs 45,000, bringing your total portfolio to Rs 120,000.

4. Calculate your current asset allocation
Determine the percentage of each asset class in your portfolio.
Example:
Equity: Rs 75,000 / Rs 120,000 = 62.5%
Debt: Rs 45,000 / Rs 120,000 = 37.5%

5. Identify deviations
Compare your current allocation to your target. If the difference is significant (usually 5% or more), it’s time to rebalance.
Example: Equity allocation is 62.5%, above the target of 60%. Debt is 37.5%, below the target of 40%.

6. Rebalance your portfolio
Buy or sell assets to restore your target allocation.
Example:
Target equity: Rs 72,000 (60% of Rs 120,000)
Target debt: Rs 48,000 (40% of Rs120,000)
Sell Rs 3,000 worth of equity and buy Rs 3,000 worth of debt.

7. Repeat periodically
Monitor your portfolio and rebalance as needed.

When to consider mutual fund portfolio rebalancing?

There are several scenarios in which investors should consider rebalancing their mutual fund portfolio:

Change in financial goals: If an investor's financial goals or risk tolerance change over time, it may require a reassessment of the portfolio's asset allocation. For example, nearing retirement may prompt a shift towards a more conservative investment strategy with a higher allocation to fixed-income securities.

Market volatility: Rebalancing during periods of market volatility can help investors maintain a disciplined approach and prevent the portfolio from becoming overly concentrated in certain assets.

Life events: Life events such as marriage, childbirth, or purchasing a home can impact an investor's financial situation and investment objectives. Rebalancing the portfolio to reflect these changes can ensure that the investment strategy remains aligned with the investor's evolving needs and circumstances.

Why rebalance a mutual fund portfolio?

Rebalancing a mutual fund portfolio offers several potential benefits:

Maintaining risk exposure: Asset allocation plays a crucial role in determining the overall risk and return characteristics of a portfolio. Rebalancing ensures that the portfolio's risk exposure remains consistent with the investor's risk tolerance and investment objectives.

Optimising return potential: Rebalancing allows investors to capitalise on market inefficiencies and potentially take advantage of opportunities to buy undervalued assets or sell overvalued ones. By realigning the portfolio with the target allocation, investors can enhance the long-term return potential.

Diversification: Asset classes may perform differently under various market conditions. Rebalancing helps maintain diversification within the portfolio, reducing concentration risk and enhancing overall stability.

Discipline and control: Rebalancing instills discipline in the investment process and prevents emotional decision-making driven by market fluctuations. It enables investors to stay focused on their long-term investment goals and avoid making impulsive changes to the portfolio.

Benefits of portfolio rebalancing during volatile markets

Rebalancing brings discipline and rational decision-making to investing, particularly during periods of market turbulence. It is especially critical in volatile markets for the following reasons:

1. Maintaining your risk profile
Volatility amplifies asset fluctuations, leading to faster deviation from your target allocation. If not rebalanced, overperforming assets can increase risk beyond your comfort level, making your portfolio riskier than intended.

2. "Buy low, sell high"
Volatile markets offer chances to buy undervalued assets and sell overvalued ones, helping you capitalize on market swings. Rebalancing helps overcome emotional bias by maintaining a disciplined approach, encouraging rational decisions.

3. Mitigating impact on gains
Rebalancing locks in profits when certain assets perform exceptionally well, safeguarding gains and reducing exposure to potential future declines.

4. Staying focused on long-term goals
Emotional reactions in volatile markets can lead to panic selling. Rebalancing keeps you focused on long-term objectives and avoids short-term impulsive decisions. It reinforces a disciplined strategy, critical for wealth-building over time.

5. Potential for enhanced returns
By consistently rebalancing, you're essentially buying low and selling high, potentially boosting long-term returns.

How to rebalance a mutual fund portfolio?

Rebalancing a mutual fund portfolio involves several steps:

Review current allocation: Begin by reviewing the current asset allocation of the portfolio and comparing it to the target allocation outlined in the investment plan.

Identify deviations: Identify any deviations from the target allocation, considering changes in market values and investment performance.

Execute trades: Implement the rebalancing strategy by buying or selling mutual fund units to realign the portfolio with the target allocation. Consider factors such as transaction costs, tax implications, and liquidity constraints when executing trades.

Monitor and adjust: Regularly monitor the portfolio's performance and asset allocation to ensure that it remains in line with the investor's objectives. Adjust the rebalancing strategy as needed in response to changes in market conditions or investment goals.

Conclusion

Mutual fund portfolio rebalancing is a crucial aspect of investment management that can help investors maintain a disciplined approach, avail a relatively better return potential, and manage risk effectively. By periodically realigning the portfolio with the target allocation, investors can ensure that their investment strategy remains in sync with their financial goals and risk tolerance. Using tools such as a mutual fund SIP calculator can help investors project the potential returns of different types of investments in their portfolio and accordingly see the optimum asset allocation based on their risk appetite and goals.

FAQs

What is the ideal frequency for rebalancing a mutual fund portfolio?

The ideal frequency for rebalancing a mutual fund portfolio depends on various factors, including investment goals, risk tolerance, and market conditions. While some investors rebalance their portfolios annually or semi-annually, others may choose to rebalance more frequently or in response to significant market events.

What are the potential risks of rebalancing too frequently?

Rebalancing too frequently can result in increased transaction costs, tax implications, and potential missed opportunities for portfolio growth. It may also lead to excessive trading activity and undermine the long-term performance of the portfolio. Investors should carefully consider the costs and benefits of rebalancing and adopt a balanced approach that aligns with their investment objectives.

Should I consider rebalancing during market downturns?

Market downturns present opportunities for rebalancing. Rebalancing during market downturns allows investors to potentially capitalise on undervalued assets and maintain a disciplined asset allocation. However, investors should exercise caution and avoid making impulsive decisions driven by short-term market fluctuations.

What are the benefits of portfolio rebalancing for an investor?

Portfolio rebalancing helps maintain asset allocation, manage risk, and potentially enhance returns by systematically selling overperforming assets and reinvesting in underperforming ones. It fosters disciplined investing, offers tax planning opportunities, and ensures regular portfolio review. However, transaction costs apply, and consulting a financial advisor is advisable for a suitable strategy.

What is the principle of portfolio rebalancing?

Portfolio rebalancing helps maintain a consistent risk-return profile by realigning investments with target allocation. It manages portfolio drift, follows a buy low, sell high approach, and mitigates excessive risk.

What is the main objective of portfolio rebalancing?

Portfolio rebalancing helps maintain your desired risk level and keep investments aligned with financial goals. It manages risk by correcting portfolio drift, fosters discipline by preventing emotional decisions, and may enhance returns through strategic asset allocation adjustments. It supports long-term financial planning.

How do you rebalance a portfolio?

Portfolio rebalancing involves reviewing target allocation, assessing current holdings, and adjusting investments to realign with financial goals. It includes deciding on rebalancing frequency, executing trades, and reviewing outcomes. Key considerations include transaction costs, tax implications, and deviation thresholds.

Does rebalancing a portfolio cost money?

Rebalancing a portfolio incurs costs like transaction fees, taxes, expense ratios, and exit loads. To minimize costs, rebalance only when deviations exceed a set threshold, use low-cost investments, apply tax-efficient strategies, and direct new contributions toward underweighted assets. Balancing costs against benefits ensures effective risk management and portfolio alignment.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.