Portfolio Rebalancing: Everything You Need to Know

• Date : April 23,2025

Just like you occasionally tidy up your home or reorganize your workspace to keep things running smoothly, your investment portfolio also needs some upkeep. Over time, as markets move and life evolves, your carefully chosen asset mix can start to drift. That’s where portfolio rebalancing comes in.
 

What is Portfolio Rebalancing?

Think of portfolio rebalancing as a way to keep your investments in check. You start with a plan, maybe 60% in equity and 40% in debt. But markets move. Stocks surge, bonds dip, and suddenly you’re holding 70% equity. That’s more risk than you signed up for.

Portfolio rebalancing is simply the process of realigning the weight of assets in your investment portfolio to maintain your desired level of risk and return.

However, rebalancing doesn’t always mean changing allocation between asset classes. Sometimes, it can also involve making adjustments within a particular asset class, like equity.

For example, even if you continue to hold 60% in equities, the composition of that equity portion might require change due to market movement. Rebalancing within equities can involve selling and buying stocks, eventually realigning the portfolio with intended strategy.
 

How Portfolio Rebalancing Works?

The concept is simple: if one asset class grows significantly, it may dominate your portfolio and increase your risk exposure. Rebalancing involves selling some of the overperforming assets and buying more of the underperforming ones to restore balance.

For example, you started with a 60% allocation to stocks and a 40% allocation to bonds. Over time, stocks performed well and grew to 70%, resulting in a 30% allocation to bonds. Rebalancing involves selling some stocks and buying bonds to return your portfolio to its original allocation. 

Similarly, within equities, one of the method of rebalancing involves selling position thats have become overweight or have limited potential and buying stocks those that are underweight or stocks that are doing well. This ensures your investment strategy remains aligned with your financial goals and risk tolerance.
 

Importance of Portfolio Rebalancing

Wonder why fix something that’s growing? Here’s why:

• Helps Maintain Risk Levels: Ensures your portfolio doesn’t drift into riskier territory than you’re comfortable with. If equities outperform, your portfolio may become too aggressive, increasing volatility.
• Disciplined Investing: Helps prevent emotional decision-making, such as chasing trends or panic selling during market downturns. It enforces a systematic approach to investing.
• Protects Long-term Goals: Whether it’s buying a house or retiring early, rebalancing helps you stay on track.
   

When Should You Rebalance Your Portfolio?

Investors often wonder if I should rebalance my portfolio and, if so, when. There’s no one-size-fits-all answer, but two common approaches include:

• Time-based Rebalancing: Setting a schedule to rebalance the portfolio like, quarterly, half-yearly or yearly, depending on your requirements.
• Threshold-based Rebalancing: Rebalancing when an asset class deviates by a certain percentage (e.g., 5% or more) from its target allocation.

The best month to rebalance your portfolio? This is a very common doubt that occurs in the minds of investors. The answer? Well, there’s no universal “best month,” some prefer rebalancing at year-end to align with tax planning or during market dips to buy low and sell high.
 

How to Rebalance Your Portfolio?

Rebalancing your portfolio involves a few key steps:

• Assess Current Allocation: Compare your current asset allocation with your target allocation.
• Identify Imbalances: Determine which assets are over- or under-weighted.
• Decide on a Strategy: You can rebalance by selling assets, adding new investments, or using dividends to adjust your portfolio.
• Execute Trades: Sell high, buy low, and restore balance.
• Monitor and Repeat: Keep an eye on your portfolio and rebalance periodically.
   

Advantages & Disadvantages of Portfolio Rebalancing

Advantages of Portfolio Rebalancing: 

• Better Risk Management: With time-to-time portfolio rebalancing, you can ensure that your portfolio allocation is according to your risk tolerance. 
• Alignment with Investment Goals: Whether you're investing for a child’s education, a dream home, or your retirement, rebalancing helps ensure your asset mix continues to serve those goals.
• Psychological Comfort: A well-balanced portfolio reduces stress, as investors know they are sticking to their long-term financial plan.

Disadvantages of Portfolio Rebalancing:

• Transaction Costs & Taxes: Rebalancing often involves selling assets, which may trigger capital gains taxes and brokerage fees.
• Potential Underperformance: An asset you sell might continue to perform well, making it seem like a missed opportunity. However, disciplined rebalancing minimizes speculative decision-making.
   

Portfolio Rebalancing Example

To better understand the impact of rebalancing frequency within equity asset class, let’s look at a comparative example of Portfolio A, rebalanced at different intervals, monthly, quarterly, half-yearly, and yearly. The table below highlights how these portfolios performed across key investment metrics over a given period.

Source: NJ Smart Beta. Note: All portfolios are created using 50 best stocks based on 9 month momentum out of Nifty 500 universe on respective rebalance date. Annual transaction cost is calculated by multiplying average churn (%) with 20bps (10bps for brokerage + 10 bps for STT). All portfolios shown above are back-tested models and may or may not replicate in real life. Portfolios or methodologies mentioned above should not be considered as a recommendation by NJ Asset Management Private Limited. Past performance may or may not be sustained in future and should not be used as a basis for comparison with other investments.

The data shows that CAGR increases from 17.44% (Yearly) to 22.97% (monthly) as rebalancing becomes more frequent. This is because frequent rebalancing helps maintain the portfolio’s target mix, enabling a disciplined “buy low, sell high” approach that boosts long-term returns.

Volatility remains similar across portfolios, but maximum drawdown increases slightly with lower frequency, indicating that frequent rebalancing offers marginally better downside protection by controlling risk drift.

The Sharpe and Sortino ratios, which measure risk-adjusted returns, are also highest for the monthly rebalanced portfolio and gradually decline as the rebalancing frequency reduces. This indicates that more frequent rebalancing not only improves returns but also enhances the consistency and quality of those returns by managing both total and downside risks more effectively.

However, this performance comes with a significantly higher churn cost. The Average Churn rises sharply with frequency, 363.80% for monthly, compared to 90.44% for yearly. This implies more trading activity, which may lead to higher transaction costs, tax liabilities, and operational effort for the investor.

In conclusion, while frequent rebalancing enhances returns and risk control, it also increases churn and associated costs. On the other hand, less frequent rebalancing may reduce churn and costs however, provide lower returns. 

Henceforth, there is no universal “ideal” rebalancing frequency. What works best for one investor may not suit another. The answer would depend on factors like investment goals, risk tolerance, and cost sensitivity. There’s no universal best approach, investors should choose what aligns best with their strategy, balancing returns with tax and associated costs.
 

Conclusion

Investing isn’t a one-time thing. Rebalancing your portfolio helps you stick to your investment strategy, adjust with the times, and avoid unnecessary risks. It’s a bit like checking the GPS on a road trip, you may not need to correct the course every five minutes, but a quick check now and then ensures you get where you’re headed.
 

FAQs

1) What do you mean by portfolio rebalancing?

Portfolio rebalancing means adjusting your investments to get back to your original asset mix. It helps keep your risk level in check and your goals on track.

2) When should you rebalance your portfolio?

There is no one-size-fits-all answer to this question but you should rebalance at least once a year or whenever your asset mix drifts too far from your target. Major life events or big market moves are also good times to review your portfolio.

3) What is the 5/25 rule for rebalancing?

The 5/25 rule suggests rebalancing if any asset class in your portfolio changes by more than 5% in absolute terms or by 25% relative to its target allocation. It’s a smart way to catch imbalances early.

Investors are requested to take advice from their financial/ tax advisor before making an investment decision.

MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.