Rebalancing vs Diversification of a Portfolio: Here is what you need to know

Rebalancing and Diversification are both integral parts of the portfolio construction and are inextricably linked to the point of being nearly symbiotic.

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If one is not paying regular attention, they can skew the asset mix and expose to more risk.

Creating a good investment portfolio is an art and science. Rebalancing and Diversification are both integral parts of the portfolio construction and are inextricably linked to the point of being nearly symbiotic.

Diversification is a risk management strategy which strives to smooth out unsystematic risk events in a portfolio and helps to hedge against market volatility.
Prashant Joshi – Co-Founder and Partner – Fintrust Advisors says, “The positive performance at asset and sub-asset class levels neutralizes the negative performance of others. In addition, it ensures that the portfolio isn’t singularly dependent on the success or failure of a particular investment, asset class, fund type or geography, to name a few.”

A well-diversified portfolio is an important starting point; however, Joshi explains, “portfolio gets out of balance over time, and the asset and sub-asset class weights fluctuate and change due to market movement. The result is that allocations deviate from the ideal asset mix, changing the portfolio’s risk-return profile.”

Rebalancing, on the other hand, is the act of bringing the portfolio back to its desired asset mix aligned to the investor risk-return profile. Finally, rebalancing keeps portfolio drifts under check. Such drifts, Joshi points out, “may not be evident because they can happen gradually. However, if one is not paying regular attention, they can skew the asset mix and expose to more risk.”

There are several methods to rebalance. Experts say an investor can either define a frequency with which they will continually assess the portfolio allocation’s current status or set asset allocation ranges.

In Periodic (time-based) rebalancing, Joshi says, “investors set a schedule, such as annually, and rebalance the portfolio according to that time frame. For example, every 12 months, measure the actual investment mix against the target.” Based on the variation, decide whether to make modifications or wait another year to rebalance.

In Tolerance-band (percentage-based) rebalancing, he adds, “investors establish specific thresholds that — if crossed — trigger rebalancing. However, this approach means the investor must monitor allocations more frequently than periodic rebalancing, which may only require one to check the weightings annually.” One can also consider a combination strategy, using both periodic annual rebalancing with tolerance bands.

Diversification in portfolio construction gets high importance. However, rebalancing industry experts say ensures that the portfolio and the strategy remain well-diversified and relevant in the ever-changing market context enabling the portfolio to survive through the tides of different market cycles and help accomplish the long-term investment goal. Most likely, “the diversified and rebalanced portfolio will outperform over the long term because of the stability of the market structure,” explains Joshi.

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