By Anup Bansal

The primary objective of investing is to achieve long-term and short-term financial goals and to ensure the same, it is critical to have an efficient asset allocation in place. However, selecting an appropriate asset allocation is only the beginning as it is equally important to maintain the chosen allocation over time.

This can be challenging as market conditions change frequently, leading to the portfolio’s deviation from its original target allocation. As a result, the portfolio may acquire new risk-and-return characteristics that may not be consistent with the original preferences. So, maintaining the selected asset allocation via rebalancing becomes essential.

What is portfolio rebalancing

The principle behind asset allocation is to diversify the investment portfolio by including uncorrelated or low-correlated asset classes. Asset classes such as stocks, bonds, and real estate do not always move together in the market. Therefore, the relative performance of each asset class can cause the portfolio to deviate from its original target allocation. Rebalancing allows for the maintenance of the overall volatility of the portfolio as per your risk profile while considering the time horizon.

The checklist

Portfolio rebalancing is a critical process that helps you to maintain the desired asset allocation and manage the risk of your portfolio. To start with, you need to create a checklist to evaluate whether your portfolio needs any modifications or not. The checklist should include parameters such as the investment objective, risk tolerance, time horizon, and asset allocation. The asset allocation should be aligned with the investment target and should be diversified across asset classes .

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The next step is to check if the current asset allocation meets the investment target. If the allocation is not aligned with the target, you need to add or remove assets to achieve the desired allocation. For example, as retirement approaches it is important to shift some weight from equity to debt instruments to manage the risk and generate steady income.

Types of rebalancing

There are different types of portfolio rebalancing methods, such as time-based, threshold-based, and percentage-based. In a time-based approach, you can rebalance the portfolio at fixed intervals.

In a threshold-based approach, you can set a predetermined percentage limit for each asset class and rebalance the portfolio when the actual allocation deviates from the target allocation beyond the set limit. On the other hand, percentage-based approach requires you to rebalance the portfolio to a fixed percentage allocation for each asset class. For instance, let’s say you have a target allocation of 60% equities and 40% bonds. After a year, due to market performance, the equity allocation increases to 70%. In this scenario, you can opt for a threshold-based approach and rebalance the portfolio when the equity allocation reaches 65%. You can sell some of the equities and buy more bonds to bring the allocation back to the target allocation of 60:40.

By rebalancing the portfolio once a year, you can maintain a consistent allocation to stocks and fixed income which helps manage risk and potentially improve long-term returns.

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Ideally rebalancing a portfolio once a year is sufficient, as multiple rebalancing can cause higher investment costs and the potential to account for short-term noise as an actual market movement. A well-planned and executed rebalancing strategy can help you optimise your portfolio and achieve long-term financial goals.

The writer is co-founder, Scripbox