What is portfolio rebalancing and how does it help?

So many times, we have heard analysts stressing the need to rejig our portfolios to ensure their diversification. This is because many people find portfolio rebalancing boring, especially, in a bull market. Also, many investors are not aware of the right way to churn the portfolio to ensure that it is balanced and yields optimum returns. A lot depends on what kinds of investments you have made and their weight in the portfolio.

Once you learn how much weight each company in your portfolio holds, you can make the required investment or rearrange them as desired. Churning is necessary considering the regular movement of share prices within a period and how some companies grow faster compared to others in the index.

Rebalancing your portfolio

You must first be aware of how to balance your portfolio before proceeding to rebalance it. Rebalancing essential involves bringing your current portfolio to its original weight. The idea is risk control or aversion by not allowing your portfolio returns to be affected by the performance of a single company alone. Also, company performances are bound to change in the long run, which is why you must ensure a timely rebalancing so that you may pull down the weaker companies to give space to fundamentally stronger companies in your portfolio.

How you value stocks is the deciding factor behind every rebalancing act. This will prevent you from overvaluing or undervaluing stocks before deciding how much you wish to invest in them or how long you wish to stay invested in them. Stocks of fundamentally strong companies stay strong or bounce back when the market is conducive, thus, underlining their significance in your portfolio.

Dev Ashish, Founder, Stable Investor says, “Periodic rebalancing of a multi-asset portfolio is the best bet for common investors to generate sufficiently high inflation-beating returns as well as manage risk. But when it comes to the regular rebalancing of a direct stock portfolio where weights of individual stocks have to be managed, then it’s a slightly different game. It won’t be wrong to call it fine art. Rebalancing will not boost returns per se. It may occasionally lower them if you reduce allocation to a stock which continues to do well after you cut exposure to it.”

How to rebalance your portfolio?

Rebalancing is easier said than done. This is because you have to consider selling the shares of companies whose weight or proportion may have gone up considerably. You must then decide how many shares of that company you would sell to bring back to its original proportion. You can decide the proceeds of those shares to invest in companies whose weights have been done and must be topped up to ensure a fair balance of stocks and market capitalization in the portfolio.

Suresh Sadagopan, founder of Ladder7 Financial Advisories says, “As long as it is an investment portfolio and not just a trading portfolio, it can be reviewed and suitable actions are taken once a year. Frequent reviews are required only if some tactical calls have been taken which we do not suggest.”

Deciding on the frequency of portfolio rebalancing depends on a lot of factors related to your financial goals. Anything done in excess hurts while staying complacent with your investments will ruin the purpose for which you had parked your funds in them. So, consider rebalancing at least once a year, if not more though a lot depends on how macroeconomic factors may trigger the growth of a certain sector or doom the future of another.

Ashish says, “Rebalancing must be done once in a while to ensure that all the stocks in your core portfolio have a reasonable but not too high an asset allocation that it exposes your portfolio to concentration risk.”

New growth triggers companies’ earnings that reflect their growing weightage in the portfolio. The idea is to then trim down to their original weight so that you have a balanced portfolio that does not succumb to sudden market volatility and performs even with most odds stacked against it.

“Nobody has a crystal ball to tell which is the next multibagger. So being practical, we need and should diversify. That way, we avoid complete ruin and also winners can compensate for a few occasional losers that might be part of our stock portfolios,” Ashish added.

An alternative to rebalancing

It is okay if you do not want to sell your winners early and prefer to wait for more seasons to pass before earning from their sales. Then, you must look at shares that have not performed despite all fundamentals being in place. It is good to wait, but surely you cannot wait till eternity, and hence, you may consider getting rid of them or striking them out of your portfolio.

Gaurav Rastogi, CEO of Kuvera says, “A lot depends on how you enter and exit different stock positions. If you have a long-term stock portfolio then a simple strategy could be to rebalance the best and worst performing stocks back to ideal weights every three months. It keeps churn and tax incidence low while meeting long-term portfolio allocation objective within reach.”

You must be tactical in your approach while selling the shares of companies that have been performing consistently and will continue to earn for you in the distant future. A fair understanding of technical analysis apart from the fundamental analysis will help you stay ahead in the race.

Does rebalancing really help?

Not many investors are inclined to make changes in their investment portfolios. Once the stocks are decided and money parked in them, many investors look forward to their stocks reaching their target price or earning dividends from them every year. However, many investors tend to mistake the strength of their portfolios and make unwarranted changes, causing them to miss out on profits in the long run.

While rebalancing is a must, investors must take care not to churn their portfolios too often. The idea must be to churn as less as possible. This is possible only when you have a long-term investment horizon and have selected your stocks accordingly.

Ashish suggests an alternative to portfolio rebalancing through stock churning. He shares, “One can also consider investing ‘new fresh’ money more strategically instead of tinkering with existing allocations (by selling overweight stocks). So, if one to two stocks already have about 40 per cent allocation and the remaining 12-13 have 60 per cent allocation, then you can invest fresh money in any of the remaining 12-13 stocks so that the overall allocation to overweight stocks is reduced and the portfolio starts getting balanced.”

Investment roadmap

There is no hard and fast rule that can advise regarding stock churning or portfolio rebalancing. Other than how you view investments and their effectiveness in helping you create a corpus; a lot of churning is dependent on the financial conditions of the investors and their views about the country’s economy. Apart, some stocks perform only during certain cycles, which is why investors sell them when they are at their peak instead of retaining them in their portfolios for years. Sudden and extreme stock market volatility prompts many people to resort to portfolio rebalancing.

The decision to rebalance depends on the market cap of the stocks. For example, some small-cap stocks perform exceptionally well and grow into the league of large-cap stocks while some mid-cap stocks tend to show much lesser growth than their peers. If you are not sure of the future of the stocks that you have bought or have second thoughts regarding their potential, it is better to replace them with stocks with better earning and growth potential.

Ashish says, “Portfolio rebalancing and consequently stock selection decisions as completely subjective and dependent on myriad circumstances and factors. During stock churning, you must pay utmost attention to stock weightage to decide the ones that must be added and those that must be rid of.”

“And it is not just about overweight stocks. It’s also about giving each stock a minimum but not too small weight in your portfolio. There is no point in having a stock double in your portfolio when its allocation is just one per cent. Isn’t it? So, make sure that your stock ideas get sufficient exposure in your portfolio. How much? At least a minimum of five per cent, if not immediately, then eventually as you scale up your allocation to a stock idea with fresh money periodically," he added.

You may not want to rebalance when the stock market is doing well or showing an exceptionally bullish trend. But, what if the market suddenly falls by 15-20 per cent? For example, the recent Russia-Ukraine fiasco sent investors scrambling down to protect their investments. Many people panicked and lost their money, some stayed still and waited for the tide to pass on while others utilized this opportunity to add some more good stocks to their portfolio by doing away with those that had not performed as anticipated.

Sadagopan says, “New investors many times tend to get carried away and may buy or sell based on the direction of the market. Mostly it is not for rebalancing. It is to time the rise or fall in the markets and ‘take advantage.”

At the heart of it, rebalancing a portfolio is all about minimizing the risk factor. Though many veterans label it as an efficient risk management strategy, it can also help earn more returns if done properly. The idea is to ride on to those stocks that you are comfortable with. After all, rebalancing is all about smart stock picking.

You need not be an expert to decide how to reshuffle your portfolio. Just pay attention to basic facts and stay updated with how the market is performing. Know your financial goals and then decide on the right investment portfolio accordingly. You may not be able to master the art of stock selection and deletion. However, if you can figure out when and how to take any action, it would do a lot of good for your investments. Most importantly, do not react to stock corrections. Stay focused on your goals by remaining tied up with your investments based on your risk tolerance.