Rebalancing: Meaning and Importance
Rebalancing is the process by which an investor re-establish or realign their portfolio to its target allocation. Through rebalancing, you can bring back your collection to the expected asset mix. It is done using outperforming investment and underperforming assets. In this, the profits of the outperforming venture are taken out and are reinvested in underperforming assets.
The portfolio rebalancing is done to establish a better risk control. Rebalancing ensures that your portfolio is not only dependent on the success or failure of the particular investment or any fund type. It has a safer side associated with it. As an investor, you have to see the risk-minimizing strategy, and it works as a risk-minimizing program for you. By periodic portfolio rebalancing, you can align your investment with your goals.
When you invest in mutual funds, you are spending to achieve a single goal via various vehicles. So when you rebalance, the shift must occur across all of these funds at the same time.
Step involved in Rebalancing your portfolio
Here are the five simple steps which will guide you to rebalance your portfolio:
Step 1: The primary and essential step is to have an asset allocation strategy. You can do this by considering your income. It includes things like the expected time of your retirement, etc. Create a framework for asset allocation will help you a lot. If you are not sure about your planning, then you can take help of experts and internet.
Step 2: Identify your current status of the asset and find where and how your current investments are placed on stocks, cash, bonds, or any other form of investment. Evaluate your current asset allocation. After doing the analysis, make a comparative analysis of asset allocation target and its present state. When you are sure about your goal, then accordingly, make adjustments.
Step 3: Make a list of a rebalancing plan in your asset allocation target, which does not align with your current portfolio. This step of the rebalancing process can be a little terrifying because here you will have to decide about which securities to keep and in what numbers.
Step 4: When it comes to tax implications, especially on capital gains, you have to be calm and mindful. Avoid any short term taxes on capital gains that allow you to hold on to your equities for over a year. The short-term capital gains will qualify for fees based on the income tax slab of an individual; for debt funds. For a long-term three years capital gains, the tax is 20% with indexation. If you want to scale back, try to sell the securities in the tax-exempt accounts first. In this way, you will limit the taxes you pay in capital gains.
Step 5: It is recommended to review your portfolio once a year or maybe once in 6 months. It will help you to assess your position but rebalance it only when you feel that the allocations are significantly out of the track in achieving the target.