The number one thing that most investors get wrong about investing in mutual funds is that they want to build but not maintain. An initial portfolio make-up that perfectly aligns with your investment goals will not stay that way forever. Portfolio adjustments or rebalancing, much like regular oiling of a car, must be made to ensure steady returns throughout the tenure. Let’s get to know all about it.
What does Portfolio Rebalancing mean?
Investing in the mutual funds market is never a ‘fit and forget it’ deal. Even for ‘buy and hold’ investors, periodic maintenance of the portfolio is mandatory to ensure positive returns. This is where rebalancing a portfolio comes in – it is the act of returning one’s current investment allocations back to their original allocation value. This process ensures a mix of investment assets that are best-suited to your risk tolerance and investment objectives.
Portfolios naturally tend to get out of balance over time as prices of individual investments tend to fluctuate, and rebalancing sets them on the right track. When it comes to rebalancing, you have two options – Selling one investment and buying another or allocating additional funds to stocks or bonds.
Additional Read: Benefit of Asset Allocation in the Portfolio
Why is portfolio rebalancing important?
To understand the importance of rebalancing a portfolio, it is necessary to revisit balancing. Balancing a portfolio means investing in fund types in a manner that perfectly aligns with the investor’s risk appetite and investment goals. To you, the asset allocation could look like 80% stocks and 20% bonds.
Now, over time, certain funds will perform better than the other, thereby disturbing this balance. Say the stocks market performed better than the bonds market, making your asset allocation 90% stocks and 10% bonds. You are now out of balance as this new aggressive allocation exposes you to greater risk than you can tolerate. Similarly, having the other way around (bonds market performing better than the stocks market) may now lower your risk level, exposing you to the possibility of losing out on gains in the stock market.
Either of the unfavourable scenarios can be avoided simply by rebalancing your investment portfolio on time.
Additional Read: Why should an investor do a periodic portfolio review?
The right time to rebalance your portfolio
Often, investors are confused as to when is the right time to rebalance their portfolio. Simply put, there are two main ways in which portfolio rebalancing can be approached – one is rebalancing at fixed, regular intervals (typically, annually), or investors may also choose to rebalance their portfolio when it’s clearly out of balance. The rule of thumb is to rebalance the portfolio periodically; however, there’s no right or wrong way of doing so.
In most cases, rebalancing the portfolio once or twice a year is sufficient to prevent the portfolio’s value from becoming extremely volatile.
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