Portfolio Rebalancing: When It's Needed and How to Do It

Consider an investor, Kanchan, who begins with ₹1 lakh allocated towards a long-term financial goal. She invests ₹75,000 in an equity mutual fund and ₹25,000 in a fixed-income mutual fund. Her starting asset allocation is therefore 75% equity and 25% fixed income.

Now assume that over the following year, the equity investment increases by 25% while the fixed-income investment grows by 7%. These are illustrative one-year returns, not forecasts. At the end of the year, her equity investment is worth ₹93,750 and her fixed-income investment is worth ₹26,750. Her overall portfolio has grown to ₹1,20,500.

Although she has not bought or sold anything, her equity allocation has increased to approximately 77.8%, while fixed income now represents 22.2%. The portfolio is doing well in absolute terms. But its composition is no longer exactly what it was when she began. That is portfolio drift.

The same thing can happen in the opposite direction. If equities fall while fixed-income investments remain relatively stable, the equity allocation may decline below the intended level. Neither situation automatically tells us what transaction to make. The investor needs to understand why the original allocation was chosen and whether the difference is now meaningful.

Kanchan's 75:25 allocation is simply an illustration. It is not a recommended allocation for every investor or every long-term goal.

Investors generally welcome an increase in the value of their investments. It can seem strange to suggest reviewing a portfolio precisely because it has performed well. But the amount of money accumulated and the risk being taken are two different considerations.

Suppose Kanchan's equity allocation continues increasing over the following years. What began as 75% equity eventually becomes 85%. Her portfolio now has substantially more exposure to equity-market movements than originally intended. If a sharp market decline occurs, a larger proportion of her accumulated wealth is exposed to that decline.

That additional risk may be perfectly acceptable if the original strategy called for it. But if Kanchan and her Investment Manager had deliberately established 75% as the appropriate equity exposure for her goal, allowing the portfolio to drift indefinitely could undermine that decision. Rebalancing can help bring the portfolio back towards the level of risk that was consciously chosen. The reverse is also true.

After a prolonged equity-market decline, an investor may find that equity exposure has fallen materially below the intended allocation. Restoring the original balance could involve directing additional capital towards equity investments. However, that decision should arise because the original allocation remains appropriate, not because someone believes the market has reached its lowest point. This is an important distinction.

Rebalancing is not a method of forecasting when to buy or sell. Nor does it guarantee better returns than leaving the portfolio untouched. Its purpose is to prevent changes in market values from silently becoming changes in the investment strategy.

There is another consideration. Strong investment performance may have brought a financial goal substantially ahead of its expected funding position. In that situation, the investor may no longer require the same level of investment risk. The correct response might then be to reconsider the intended allocation itself, rather than mechanically restore the previous proportions.

The goal's requirements must continue to determine the portfolio, not the other way around.

Drift changes the risk a portfolio carries, even when returns look strong. Moving from 75% to 85% equity increases equity exposure; if the original 75% allocation still suits the goal, rebalancing can restore the intended balance.

There is no single percentage that makes rebalancing necessary for every investor. A portfolio moving from 75% equity to 77.8% equity may not require any immediate action. For one investor, the difference could be too small to matter. For another, the implications may be more significant because of the amount involved, the financial goal or the time remaining.

Consider Kanchan's original example. Her allocation has shifted by less than three percentage points. If the goal remains distant, the portfolio is otherwise suitable and she continues making regular contributions, it may be reasonable to allow the normal investment process to continue. There may be no meaningful advantage in selling investments simply to restore the exact original percentages.

Now imagine that after several years, the allocation has moved substantially further from its intended balance. The portfolio could then be taking noticeably more risk than Kanchan originally chose. Restoring the balance may deserve greater consideration. Even then, the decision cannot be made by looking at the percentage difference alone.

The review should consider the financial goal, how much money has accumulated, the time remaining, the intended portfolio allocation, the investor's financial position and the costs of making a change. A deviation that is acceptable for a distant accumulation goal may deserve different treatment when the money is close to being required. At the same time, a financial goal moving closer can itself change the allocation that is appropriate. That is a separate question from whether the portfolio has drifted away from its original mix.

The important point is that a percentage should inform the review, not replace the judgement behind it.

Yes. Selling part of an investment and buying another is only one way to restore an allocation. In many situations, especially during the accumulation years, money that is already being contributed can help bring the portfolio back into balance. Return to Kanchan's portfolio.

After the illustrative first year, she has ₹93,750 in equity and ₹26,750 in fixed income, for a total of ₹1,20,500. If she has ₹4,500 of additional money genuinely available for investing, directing that amount towards fixed income would bring the total portfolio to ₹1,25,000. Her equity allocation would then be exactly 75%, without redeeming any equity investment. This assumes investment values remain unchanged while the contribution is made.

Of course, Kanchan shouldn't invest an additional ₹4,500 merely to make the percentages look tidy. The money must be available after considering her other financial requirements. If she is already contributing through SIPs, there may be an even simpler option.

Instead of continuing to direct all fresh investments towards the same allocation, she could temporarily direct a greater proportion of new contributions towards the underweighted asset class. Over time, those contributions may help restore the intended balance. This approach can be particularly useful when the drift is modest, contributions are meaningful relative to the portfolio's size and there is enough time for the adjustment to take effect. But it has limitations.

As the accumulated portfolio becomes larger, monthly contributions may represent only a small fraction of the existing investments. Redirecting fresh money could then take too long to correct a substantial imbalance. In such a situation, some of the existing investments may need to be reallocated. In Kanchan's original example, restoring the 75:25 balance without adding new money would require moving approximately ₹3,375 from equity to fixed income, before accounting for transaction costs, taxation or subsequent market movements.

The reallocation could involve redeeming units and investing the proceeds in the appropriate destination. Depending on the investments involved and whether phased movement is suitable, a Systematic Transfer Plan may help implement the change. An STP, however, is still a sequence of redemptions and purchases. It does not automatically eliminate tax consequences or exit loads.

The right implementation method depends on the size and urgency of the adjustment, the available contributions, liquidity requirements and the costs involved. The objective should not be to avoid selling at all costs. It should be to make the necessary adjustment in a sensible and proportionate manner.

Not necessarily. At FinEdge, we generally conduct periodic portfolio reviews once a year. We also revisit investment strategies when significant life events or developments in financial goals warrant attention. These reviews help establish whether the investments remain appropriate and whether any adjustment would improve the portfolio's alignment with its purpose.

But a review is not an instruction to transact. An annual review may show that the portfolio's allocation remains sufficiently close to the intended balance. Even if there has been some drift, the difference may not be meaningful enough to justify immediate rebalancing. The correct decision may simply be to continue.

In another year, changes in the relative value of investments may have produced a substantial imbalance. A rebalancing decision could then be appropriate. A major life event or a change in financial goals can also trigger a review, but these circumstances deserve special consideration.

For example, if someone decides to retire earlier than originally planned, the portfolio's intended allocation may need to change. Returning to the old allocation before examining the new retirement timeline could be counterproductive. Similarly, receiving a substantial inheritance may alter the overall investment position and create opportunities to allocate additional capital differently. These situations require understanding the investor's new circumstances before deciding whether the portfolio needs rebalancing, restructuring or simply a change in future contributions.

The review determines whether a change is needed. Rebalancing is only one possible outcome.

When rebalancing requires redeeming existing investments, the consequences of those transactions matter. For mutual funds, selling units may result in taxable capital gains. Exit loads can apply to certain schemes depending on their terms and holding periods. The treatment will vary with the type of fund, the investment history and the transaction being considered.

These costs should be understood before the change is implemented. An investor who repeatedly sells and reinvests to correct relatively small allocation differences may create avoidable expenses and unnecessary complexity. There is also the question of what happens after the transaction.

Reducing equity exposure means less of the portfolio will participate if equity markets continue rising. Increasing equity exposure means accepting more of the downside if markets subsequently decline. Neither of those possibilities makes rebalancing inherently right or wrong. They are consequences of changing the allocation.

The decision should therefore be justified by the risk the financial goal requires, not by an expectation that the next market movement will reward the transaction. It is also worth examining whether the proposed adjustment is large enough to have a meaningful effect on the portfolio. Selling an investment simply because it has performed well can be just as arbitrary as replacing a fund simply because it has performed poorly. What matters is whether the current portfolio continues to represent the allocation that was deliberately established.

Where it does not, the appropriate adjustment should be evaluated alongside transaction costs, available alternatives and the time over which the change should happen.

The most important limitation of rebalancing is that it assumes the intended investment strategy is still appropriate. If the original allocation no longer suits the investor's financial situation or goals, returning to that allocation is not necessarily the right decision. Consider an investor whose portfolio was constructed with a long-term retirement objective. Over the years, their financial position improves substantially, and the accumulated corpus becomes sufficient to support the retirement requirement under more conservative assumptions.

The investor may now have less need to pursue growth through the same level of equity exposure. In that situation, deciding on a new allocation is a strategy decision. Rebalancing can help implement the new structure, but it cannot decide what that structure should be. The same principle applies when a goal has moved closer, financial responsibilities have changed or the original risk exposure has become unsuitable.

It also helps to distinguish rebalancing from replacing a particular mutual fund. A fund may no longer fulfil its intended purpose because of a material change in its mandate, management or investment approach. Replacing it could be justified even if the portfolio's overall equity and fixed-income allocations remain unchanged.

Conversely, a fund may underperform for a period without any fundamental change in its suitability. Replacing it simply to move towards the recent outperformer is not portfolio rebalancing. Our article on when to change your investment strategy examines these distinctions in greater detail. The questions are connected, but they are not interchangeable.

Rebalancing restores the intended allocation when that allocation remains appropriate. Redesigning a strategy changes what the allocation should be. Replacing an investment addresses a specific holding. And sometimes, after examining all three possibilities, the best decision is not to change anything.

Rebalancing restores a plan; it cannot tell you whether the plan is still right. When the goal, the time left or your circumstances have changed, decide the allocation first and use rebalancing only to implement it.

A well-constructed portfolio will not maintain exactly the same proportions forever. Different investments will perform differently, contributions will continue, withdrawals may begin and the investor's financial circumstances will evolve. The purpose of portfolio rebalancing is to make sure those changes do not unintentionally move the investments away from the risk and allocation that the financial goal requires.

There will be times when using fresh contributions is sufficient. At other times, adjusting existing holdings may be necessary. And there will be situations where the appropriate response is to reconsider the investment strategy itself. The important decision is not simply whether equity has risen or fallen, or whether a particular asset class has become more attractive.

It is whether the current portfolio is still appropriate for what the investor needs the money to accomplish. A good review should make that clearer, whether the eventual conclusion is to rebalance, redesign or continue. The goal remains the reason for investing. The portfolio should continue to reflect it.