Investing in mutual funds involves selecting the right mix based on your objectives, which is one task. Over time, however, the market movements distort this balance. For example, equity funds may surge during a bull phase, while debt might lag behind, and such a situation can leave a portfolio tilted toward higher risk than originally intended.
This is where the concept of rebalancing comes into effect, which ensures your portfolio is aligned with your objectives/goals and risk acceptance, even when the market is unpredictable.
Here is a structured and practical approach to ‘how to rebalance your mutual fund portfolio’.
Steps to Rebalance Your Investments:
The following steps guide you through ‘how to rebalance your mutual fund portfolio:
Determine Your Asset Allocation
Rebalancing begins with a reference point, which is asset allocation. And, without a defined allocation, there is nothing to return to.
The asset allocation acts as the framework that holds your portfolio together. It must reflect these three forces that work together: time horizon, financial goals, and tolerance for risk. For instance, a younger investor may hold a higher equity share, while someone nearing a goal might shift toward stability.
This step is emphasised by industry guidance because rebalancing is not about reacting to markets, but returning to a pre-decided structure that already accounts for uncertainty.
Review Your Present Allocation
Even though your portfolio may be distorted with market activities over a period of time, it does not remain still. The returns/performance of equity or debt funds tend to change. The function here is to assess how far the current allocation has deviated from the original plan.
Let’s say, under certain circumstances, equity markets performed strongly over two years. The equity-to-debt allocation of 70:30 may shift to 80:20. At first glance, this appears beneficial, and the portfolio appears to have grown. However, the risk profile has also changed.
Rebalancing begins with this realisation that not all growth is healthy if it distorts structure.
Decide What to Buy or Sell
This step involves selling portions of overperforming assets and reallocating to underrepresented ones. If equity has risen beyond its intended share, it is trimmed, and the funds are redirected towards debt or diversified schemes.
Recent portfolio reviews in India show a similar approach. Experts recommend booking profits in outperforming funds and reallocating toward segments that improve diversification, such as shifting from concentrated small-cap exposure to multi-cap or mid-cap funds. It is a restoration of proportion.
Establish Tolerance Bands
Since markets are not static, minor deviation shall not trigger constant buying and selling. In this context, tolerance bands act like a buffer, where instead of reacting to minor ups and downs, a permissible range is defined.
For example, suppose you decide to keep 50% in equity and set a 4% tolerance band. It means your equity allocation can move up or down by 4%, from the target. That is, your portfolio can fluctuate between 46% and 54% in equities.
Use a Strategic Rebalancing Approach
Rebalancing can follow two primary approaches.
- Time-based rebalancing involves reviewing the portfolio at fixed intervals, which can be annual.
- Threshold-based rebalancing, on the other hand, is triggered when allocation deviates beyond a defined limit, for example, more than the set tolerance band of 4%.
Know Your Tax Implications
Alongside timing and method, the cost of rebalancing also requires some attention.
In India, the profit earned from the sale of equity mutual fund units attracts different tax rates depending on the holding period. Long-term capital gains (LTCG) over ₹1.25 lakh in a financial year are taxed at the rate of 12.5%, while short-term gains are taxed at a higher rate of flat 20%.
The debt mutual funds follow a separate structure, where, irrespective of the investment period, gains are taxed as per the investor’s income tax slab applicability.
This introduces a layer of decision-making. Some investors might also rebalance through fresh investments, directing new capital into underweight assets.
Regular Portfolio Monitoring
For an investor, rebalancing is not a one-time event. It is an ongoing discipline. Experts consistently advise periodic reviews, especially after strong market movements or at least once a year.
There is also a subtle balance to maintain. Excessive rebalancing can interrupt compounding, particularly in long-term SIP portfolios. At the same time, ignoring allocation drift can also increase risk.
Conclusion
When viewed as a whole, the approach is both practical and disciplined. Rebalancing keeps a portfolio aligned with its original allocation, even when the market moves unfavourably. It is about maintaining proportion. By reviewing allocations, acting within defined limits, and considering costs, investors bring discipline into their decisions. Over time, this process helps manage risk and supports consistency, which matters much more than chasing returns.
FAQ’s
The 5/25 rule sets a trigger for action. In this approach, you rebalance your portfolio when an asset class moves either 5% points away from its target or by 25% of its original allocation, whichever is smaller. It helps avoid frequent adjustments while still controlling major deviations.
The 7-5-3-1 rule is an expectation framework for SIP returns over time. It suggests that returns may average around 7% in the long term, 5% over medium periods, and lower in shorter durations. It is not a formula, but a way to set realistic return expectations.
The 50-30-20 rule is an allocation approach. It suggests investing 50% in equity for growth, 30% in debt for stability, and 20% in safer or liquid assets. The idea is balancing returns with risk while maintaining liquidity for short-term needs.
Warren Buffett suggests a simple allocation strategy. He recommends allocating 90% of the capital into a low-cost equity index fund and 10% into government bonds. This approach focuses on simplicity, low costs, and long-term growth without frequent portfolio adjustments.
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