Calendar, threshold-based rebalancing: Understand the approaches to portfolio rejig

Portfolio rebalancing to adhere to asset allocation plan is a must during stock market rise as well as fall

During bull markets and strong portfolio performance, rebalancing often gets overlooked. However, this seemingly routine exercise plays a crucial role in long-term investment success.

Portfolio rebalancing extends beyond mere number-crunching; it enforces discipline, aligns investments with individual objectives, and frequently drives superior risk-adjusted returns.

Understanding portfolio rebalancing

Portfolio rebalancing involves adjusting asset allocations to restore predefined targets. When an investor maintains a 60:40 equity-debt portfolio and equity markets surge, the equity component might expand to 70 percent. Rebalancing requires selling some equity and purchasing debt to restore the original ratio.

The mathematical concept appears straightforward, but the strategic purpose runs deeper. Rebalancing prevents concentration risk, maintains intended risk exposure, and instils a counter-cyclical approach, systematically encouraging investors to sell high and buy low.

Market cycles and strategic timing

The early 2020 (Covid 19 outbreak) market scenario provides a compelling example. A Rs 1 crore portfolio with 60:40 equity-debt allocation experienced significant equity drawdowns during the pandemic-induced crash. By April 2020, the equity portion had fallen below Rs 45 lakh. Investors who rebalanced by shifting debt funds into equity positioned themselves to capitalise on the sharp recovery over the following 12 months. Those maintaining static allocations often missed opportunities to enhance long-term returns.

This demonstrates how strategic rebalancing not only mitigates risk but can amplify returns by embracing volatility through disciplined frameworks.

Multiple approaches to portfolio rebalancing

·  Calendar-Based Rebalancing: Conducted annually or semi-annually, this method offers easy implementation while reducing temptation to react to short-term market noise.

·  Threshold-Based Rebalancing: Triggered when asset allocation deviates from targets by predetermined percentages (typically +/-5 percent). This approach requires more frequent monitoring but responds dynamically to market movements.

Many investors adopt hybrid approaches, combining both methods to maintain balance without excessive portfolio churn.

Also read: The rise of Specialised Investment Funds: A new frontier for Indian investors

Asset allocation drift risks

Over time, varying asset class returns can significantly alter portfolio risk profiles – a phenomenon called asset allocation drift. This exposes investors to risk levels inconsistent with original objectives.

A moderately conservative investor with 50:50 equity-debt allocation could unknowingly face higher risk exposure if equity markets outperform over two to three years. Without rebalancing, the portfolio might resemble an aggressive investor's allocation, carrying associated risks without conscious intent.

Also read: Why multi-asset allocation funds make sense in the current market cycle

Navigating taxes and transaction costs

Taxation remains a primary rebalancing deterrent. Selling appreciated assets triggers capital gains, and debt mutual funds now face slab rate taxation for most categories post-April 2023. Frequent rebalancing can also increase transaction costs.

Cash flow-based rebalancing offers a solution. This approach uses fresh inflows like bonuses, SIPs, or maturing fixed deposits, to restore intended allocations without liquidating existing investments. Similarly, retirement portfolios can structure planned withdrawals to achieve rebalancing objectives.

Behavioural benefits

Rebalancing's behavioural impact represents one of its most under-appreciated aspects. It creates structure that counters emotional investing. During market euphoria, it encourages profit-booking; during pessimism, it guides allocation toward undervalued assets. This builds disciplined, contrarian frameworks into portfolio management. This behavioural management proves particularly valuable during sharp market movements, where fear and greed can override rational decision-making.

Predetermined rebalancing strategies protect investors from both overexposure and missed opportunities.

Technology and human judgment

Digital investment platforms increasingly offer automatic rebalancing, particularly for ETF portfolios and goal-based models. While these tools promote consistency, human oversight remains important. Market shifts are not always symmetrical or rational. Significant changes such as rising geopolitical risks or structural asset class shifts may require discretion beyond algorithmic capabilities.

The strategic imperative

Rebalancing may appear mundane during rising markets, but its value emerges retrospectively, when volatility returns or long-term goals are achieved with reduced stress.

Rebalancing goes beyond simple math as it brings structure and discipline to investment decisions. In today's unpredictable markets, it's one of the most dependable strategies investors have, helping them stay on track while keeping control of their financial future.