What is Portfolio Rebalancing?
Portfolio rebalancing is the process of adjusting the allocation of assets in an investment portfolio to maintain a desired level of asset allocation or risk. Over time, due to market fluctuations, the value of individual assets in a portfolio will change, which can lead to an asset allocation that differs from the investor’s original strategy or risk tolerance.
Setting Targets: Initially, an investor decides on a target asset allocation based on their investment goals, risk tolerance, and investment horizon. This allocation typically involves a mix of different asset classes such as stocks, bonds, and cash.
Market Movements: Over time, the value of these assets will change due to market movements. For example, if the stock market performs well, the proportion of stocks in the portfolio might increase beyond the desired allocation.
Rebalancing: To rebalance, the investor will sell assets that have grown beyond their target percentage and buy assets that have fallen below their target percentage. This brings the portfolio back to its original asset allocation.
Frequency of Rebalancing: Rebalancing can be done at regular intervals (like annually or semi-annually) or when the allocation deviates beyond a certain threshold from the target allocation.Many mutual funds rebalance at regular intervals, such as quarterly, semi-annually, or annually. This is often dictated by the fund’s prospectus.
Threshold-Based Rebalancing: Some mutual funds use a threshold-based approach, rebalancing when an asset class’s weight in the portfolio deviates by a certain percentage from its target.
Rebalancing Explain with a Simple Example
To illustrate portfolio rebalancing with a simple example, let’s assume you have a portfolio comprising five assets: RELIANCE, HDFCBANK, TCS, ICICIBANK, and GOLDBEES. Each of these assets is allocated a fixed percentage of the total portfolio value. Let’s say the initial investment is ₹1,00,000, and the allocation is as follows:
- RELIANCE: 20%
- HDFCBANK: 20%
- TCS: 20%
- ICICIBANK: 20%
- GOLDBEES: 20%
This means that initially, each asset is allocated ₹20,000 (20% of ₹1,00,000).
Now, let’s assume that over a period, the total value of the portfolio increases to ₹1,20,000 due to market movements. The individual values of these assets would have changed, potentially altering their proportion in the total portfolio. Let’s look at a hypothetical scenario of how their values might have changed:
Initial Investment
| Asset | Allocation | Initial Value (₹) |
|---|---|---|
| RELIANCE | 20% | 20,000 |
| HDFCBANK | 20% | 20,000 |
| TCS | 20% | 20,000 |
| ICICIBANK | 20% | 20,000 |
| GOLDBEES | 20% | 20,000 |
| Total | 100% | 1,00,000 |
Value After Market Changes (Total Portfolio = ₹1,20,000)
Let’s assume the values of these assets have changed as follows:
| Asset | New Value (₹) | New Percentage |
|---|---|---|
| RELIANCE | 25,000 | 20.83% |
| HDFCBANK | 24,000 | 20% |
| TCS | 23,000 | 19.17% |
| ICICIBANK | 26,000 | 21.67% |
| GOLDBEES | 22,000 | 18.33% |
| Total | 1,20,000 | 100% |
Rebalancing to Original Allocation
To rebalance, we need to bring each asset back to its original allocation of 20%. This would mean each asset should be valued at ₹24,000 (20% of ₹1,20,000). Here’s how you would rebalance:
| Asset | New Value (₹) | Desired Value (₹) | Action |
|---|---|---|---|
| RELIANCE | 25,000 | 24,000 | Sell ₹1,000 worth |
| HDFCBANK | 24,000 | 24,000 | No action needed |
| TCS | 23,000 | 24,000 | Buy ₹1,000 worth |
| ICICIBANK | 26,000 | 24,000 | Sell ₹2,000 worth |
| GOLDBEES | 22,000 | 24,000 | Buy ₹2,000 worth |
| Total | 1,20,000 | 1,20,000 |
After rebalancing, each asset should be back at a 20% allocation of the total portfolio value.
Inclusion of New Stock into the Portfolio
Continuing with the previous example, let’s introduce a new stock, TATAMOTORS, to the portfolio and see how the rebalancing would work. We’ll assume that you want to incorporate TATAMOTORS into the portfolio with a specific allocation, and adjust the allocations of the other assets accordingly.
For simplicity, let’s say you want to allocate 20% to TATAMOTORS. Since the total allocation must add up to 100%, you need to reduce the allocation of the other assets. Let’s allocate 16% each to RELIANCE, HDFCBANK, TCS, ICICIBANK, and GOLDBEES to accommodate the new asset.
Adjusted Allocation with TATAMOTORS (Total Portfolio = ₹1,20,000)
| Asset | New Allocation | Adjusted Value (₹) |
|---|---|---|
| RELIANCE | 16% | 19,200 |
| HDFCBANK | 16% | 19,200 |
| TCS | 16% | 19,200 |
| ICICIBANK | 16% | 19,200 |
| GOLDBEES | 16% | 19,200 |
| TATAMOTORS | 20% | 24,000 |
| Total | 100% | 1,20,000 |
Rebalancing to Include TATAMOTORS
Now, let’s rebalance the existing assets to accommodate TATAMOTORS:
| Asset | Pre-Rebalance Value (₹) | Adjusted Value (₹) | Action |
|---|---|---|---|
| RELIANCE | 25,000 | 19,200 | Sell ₹5,800 worth |
| HDFCBANK | 24,000 | 19,200 | Sell ₹4,800 worth |
| TCS | 23,000 | 19,200 | Sell ₹3,800 worth |
| ICICIBANK | 26,000 | 19,200 | Sell ₹6,800 worth |
| GOLDBEES | 22,000 | 19,200 | Sell ₹2,800 worth |
| TATAMOTORS | 0 | 24,000 | Buy ₹24,000 worth |
| Total | 1,20,000 | 1,20,000 |
After the rebalancing, each of the older assets has been reduced to create space for the new investment in TATAMOTORS, keeping the total portfolio value at ₹1,20,000.
Investors need to be aware of potential transaction costs and tax implications when rebalancing, as selling assets can generate capital gains taxes.
