How should you rebalance mutual fund portfolios? (2024)

What is portfolio rebalancing?
Every individual should build a long-term asset allocation policy taking into consideration risk-taking ability, goals, and the time frame available. Asset allocation decides what percentage will be allocated to equity, fixed income, and gold. Typically, a conservative investor will have 50% in equity, 40% in fixed income, and 10% in gold. Since asset classes could move in different directions over a period of time, even without making any active changes or tampering with the portfolio, it is but natural that the original decided asset allocation changes. For example, when equities rise and gold falls, allocation to equity could rise in the portfolio and that of debt and gold will fall. Portfolio rebalancing is a process of buying and selling holdings in your portfolio in order to set the weight of each asset class back to its original state. Also, since the time you built your portfolio, there is a probability that your investment strategy or risk-taking ability too, has changed. Rebalancing takes both these things into account and adjusts the weight of each asset class in the portfolio.

How should investors rebalance portfolios?
For mutual fund investors, one can simply redeem units from an asset class which has grown more and add that to the asset class whose proportion fell. If you are adding fresh money, you could consider adding to the asset class that has lagged. This will increase the value of this asset class and bring it back to the original desired allocation.

Why is it necessary to carry out this exercise?
Financial planners believe it is important to rebalance portfolios to manage risk. For example, a low-risk investor needs to allocate 40% to equities. However a rising stock market could increase its allocation to 55%, which means the investor is taking more risk than he intended to, and in case of a fall in equities, it could hurt him more. Hence, restoring the original allocation will keep the risk within your tolerance limit. Rebalancing also helps one to book profits in a rising asset class and invest in another that has not risen. So, if the equity component of your portfolio has grown more sharply compared with debt when you rebalance, you book profits in equities and buy more debt.

What is the right time to do it ?

Financial planners suggest investors should rebalance their portfolios at least once a year or whenever there is a sharp movement in a particular asset class. For example, if the markets are up 50% in six months, it may be time to revisit your portfolio. So if your equity allocation was 40% and the current allocation crosses 35% or 45%, it is time to rebalance your portfolio.

What else should investors factor in while rebalancing ?

Financial planners believe investors should take into account applicable taxes and exit loads in mind before rebalancing. Selling equity held for less than a year could mean a short-term capital gains tax of 15%, as compared with selling it after a year, which brings the tax down to 10%. Similarly, some equity funds have an exit load of 1% if held for less than a year.