Year-end portfolio rebalancing: Why and how should you do it? | Mint - Mint

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With portfolio rebalancing, you can revert to the original equity and fixed income ratio you started with at the start of the year. The year-end is a good time to review your investment portfolio and rebalance it if required. Let us understand what portfolio rebalancing is, why you should do it, and how to do it.

What is portfolio rebalancing?

As per asset allocation, your investment portfolio may comprise various asset classes like domestic equity, international equity, fixed income, gold, etc. You may decide the portfolio percentage allocation to each asset class based on your age, risk profile, and other factors. Portfolio rebalancing is the process of reviewing the overall investment portfolio and reverting the percentage allocation of each asset class to the original ratio.

Portfolio rebalancing involves selling a portion of the asset classes whose percentage allocation has increased due to superior performance compared to that of other asset classes. The sale proceeds are then invested in the other asset classes whose percentage allocation has fallen due to underperformance compared to that of other asset classes.

When you sell some units of a particular asset class, its allocation in the overall portfolio falls back to the original ratio. Similarly, when you invest the sale proceeds in the units of the other asset class, its allocation in the overall portfolio rises back to the original ratio.

How does portfolio rebalancing work?

Let us understand how portfolio rebalancing works with the help of an example. Suppose you invest Rs. 1 lakh in equity and debt mutual funds in the 60:40 ratio. In this case, Rs. 60,000 will be invested in equity mutual funds, and Rs. 40,000 will be invested in debt mutual funds.

At the end of the year, suppose the equity mutual fund investment has given a return of 15%. Its value will increase from Rs. 60,000 to Rs. 69,000. Suppose the debt mutual fund investment has given a return of 5%. Its value will increase from Rs. 40,000 to Rs. 42,000. The overall portfolio value has increased from Rs. 1,00,000 to Rs. 1,11,000.

The overall portfolio has earned an 11% return. The original 60% equity to 40% debt allocation has changed to 62.16% equity and 37.84% debt. At the end of the year, while doing portfolio rebalancing, you will have to sell some equity mutual fund units so that its allocation reduces from 62.16% to the original 60%. You will have to invest the equity mutual fund sale proceeds into the debt mutual fund so that its allocation increases from 37.84% to the original 40%.

In the above example, you had to sell equities as they outperformed. However, there will be years when broader equity markets will sell off and underperform. For instance, the equity markets underperformed during the subprime crisis, Eurozone debt crisis, demonetisation, COVID-19, etc. During such times, at the time of portfolio rebalancing, you will have to sell the debt mutual fund units and invest the sale proceeds in equity mutual funds.

Why should you do portfolio rebalancing?

You should do portfolio rebalancing every year to maintain your asset allocation ratio as per your risk profile. Portfolio rebalancing is a risk management strategy. It protects you from getting over-exposed to any asset class.

When should you do portfolio rebalancing?

In the above section, we saw how portfolio rebalancing at the end of every year helps you maintain the asset allocation ratio. Apart from this, some other scenarios that may require portfolio rebalancing include the following:

Asset allocation change due to increasing age: As the age increases, with every passing year, many people prefer to reduce their equity exposure and increase their fixed-income exposure. So, as your asset allocation ratio changes, you will need to do the portfolio rebalancing.

Nearing financial goal: As you near your financial goal, you will need to sell your equity portion and move to fixed income completely.

Change in risk profile: Events like marriage, childbirth, taking a home loan, etc., may bring additional responsibility. It may reduce the risk appetite, leading to a change in the asset allocation ratio. Thus, you will need to do portfolio rebalancing.

Tax implications due to portfolio rebalancing

Portfolio rebalancing requires selling units of one asset class and buying units of another asset class. When you sell the units of an asset class, there will be tax implications. Depending on your capital gain and holding period, you will need to pay short- or long-term capital gain tax.

You can invest in mutual funds that give you exposure to multiple asset classes in a single scheme and do the portfolio rebalancing without its tax implications for you. These funds include various hybrid funds, dynamic asset allocation funds, multi-asset allocation funds, etc.

Certain financial products have a specified lock-in period. For example, the Equity Linked Savings Scheme (ELSS) has a 3-year lock-in period. So, for such financial products, you can do portfolio rebalancing only after the lock-in period is over.

Portfolio rebalancing: Maintain asset allocation and manage risks better

There will be years when a specific asset class in your investment portfolio will significantly outperform others. It will tilt your overall investment portfolio in favour of that asset class and expose it to risks related to that asset class. However, portfolio rebalancing helps you revert to the original asset allocation and manage risks better. So, during the year-end, review your entire portfolio and rebalance it!

Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached at LinkedIn.

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