Various asset classes move in different directions over a period of time. As a result, asset allocation of an individual changes over time. Therefore, it is necessary to rebalance the portfolio from time to time.
As markets move up or down, your asset allocation changes. Your equity allocation could go up if markets rally for a long time, or it could go down when markets correct, thereby changing your asset allocation. Therefore, you need to rebalance it to bring it back in line with the original. Portfolio rebalancing is the process of bringing a portfolio back to its original asset allocation. While making an asset allocation, the target proportion of debt and equity is determined based on your time frame and risk profile. Over time, if one asset class moves more than another, the allocation between them may diverge from the original planned allocation. This will affect the portfolio's returns and the risk you are taking.
Why should an investor rebalance his portfolio?
Investors need to rebalance their portfolio to manage risk. For example, a low-risk investor may need 40% equity in his portfolio. But due to a rise in the stock markets, if the proportion increases to 60%, the investor is taking more risk than he intended to. Hence, restoring the original allocation will keep the risk within his tolerance limit. Rebalancing also helps one book profits in a rising asset class and investing in another, which has not risen. So, if the equity component of your portfolio has grown more sharply compared to debt, it is because of the rise in stocks markets. When you rebalance, you book profits in equities and buy more debt.
When should you rebalance?
Financial planners suggest investors should rebalance their portfolios atleast once a year or whenever there is a sharp movement in a particular asset class. For example, if the markets are up 50% in six months, it may be time to revisit your portfolio. So, if your equity allocation was 40% and the current allocation crosses 35% or 45%, it is time to rebalance your portfolio.
How should you rebalance?
You can redeem mutual fund units from an asset class which has grown more and add that to the asset class whose proportion fell. If you are adding fresh money, you could consider adding to the asset class which has lagged. This will increase the value of this asset class and restore its original allocation.
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