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Financial Term of the week- Portfolio Rebalancing

When you rebalance your mutual fund portfolio, you make sure that you are sticking to your desired asset allocation. Various types of asset classes can be equity, debt, gold, real estate, and so on; and each of these has a varying degree of risk associated with it. Your asset allocation implies the amount of investment you make in each or any of these assets, depending on your return expectation and risk appetite. For example, you may choose to have an asset allocation of 50:30:20 in favour of equity, debt, and gold, respectively. Now, you may start with this asset allocation, but with time, the value of your investments goes up and down due to market forces. This may imbalance your asset allocation to, say, 55:20:25. Portfolio rebalancing is the process of you bringing your asset allocation back to the original 50:30:20.

Why is there a need for a balanced portfolio?

Investing in one asset class alone can be risky because if it underperforms, then you may end up losing your invested money. You can mitigate these risks by investing in different asset classes. The right asset allocation strategy will determine how much of your corpus is invested in which asset class.

The concept of asset allocation also works because each asset class performs differently; which means that while one of them performs good, the other one may underperform and vice versa - just like gold and equity. Hence, staying invested in both may help you remain calm, knowing your portfolio is balanced. Apart from being one of the most important factors in determining your future returns and reducing risk, asset allocation is also required for diversification. If your aim is long-term wealth creation, then asset allocation may be key in this journey.

The need to rebalance the portfolio

Assuming you have Rs 1,00,000 and you invested Rs 60,000 in equity funds (60%) and Rs 40,000 in debt mutual funds (40%), as per your risk appetite. Now over a period of time, say 10 years, the value of equity funds grew to Rs 62,000, and the value of debt mutual funds only grew to Rs 45,000. Now in the current scheme of things, the allocation to equity and debt funds have become 58% and 42 % respectively.

Thus, you may book profits in debt and increase equity allocation so that your allocation comes back to 60:40.

Portfolio rebalancing requires you to keep a tab and check every few years if your asset allocation is in line with your initial strategy. Rebalancing also helps you keep your risks as per your risk appetite. If your risk appetite is changing, then your asset allocation may change and you may want to adopt a different rebalancing route. You may review your portfolio periodically to check the asset allocation status and make decisions accordingly.

Financial implications of portfolio rebalancing

In the above example, in order to rebalance the new portfolio value of Rs 1,07,000, you will have to redeem Rs 2200 from the debt mutual funds and re-invest them in equity mutual funds to ensure that the allocation is corrected to 60:40 again. But this redemption may involve charges that you must be mindful of-

  1. Exit Load: If you redeem within a specific period, an exit load may be levied on your redemption. It varies from one fund to another.
  2. Capital Gains Tax: Again, depending on your investment period, you can be charged a short-term capital gain tax or a long-term capital gain tax on the returns that you earn on your investment

The adjustments you make in your portfolio should be informed decisions, keeping these charges in mind. Try to minimize any financial implications that may arise due to the redemptions you are making. You are different and so are your asset allocation decisions. Rather than following someone else’s strategy, it may be better to derive on your own.

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