What is rebalancing?
Say you decide to keep 60% of your money in shares or share-based funds and 40% in fixed-income places such as an FDR or sanchayapatra. That split is your asset allocation. But if share prices rise a lot in a year, you may find shares are now 70% of the total, even though you did nothing.
Rebalancing means pulling that drifted mix back towards the plan: selling some of what has grown too large, or using new money to buy what has fallen behind. The aim is not to earn more, but to stop your risk quietly growing beyond what you planned.
Say Tanvir keeps rice and lentils in his kitchen in a 2:1 ratio. When the lentils run low mid-month, he buys more lentils, not more rice, so the ratio is right again. Rebalancing a portfolio works the same way: topping up the part that has shrunk and trimming the part that has grown too large.
Why it matters to an investor
- To keep risk under control: if you never rebalance, the share portion usually creeps up, because shares tend to grow more over long periods. Your portfolio then becomes much riskier than you planned.
- To manage emotions: rebalancing by a rule means selling a little after big rises and buying a little after big falls, the opposite of running with the crowd.
- As a goal gets close: as a goal approaches (a child’s admission, retirement), many people want less risk. Rebalancing helps make that shift step by step.
How often and how
There are usually two approaches. With the calendar approach, you check the mix at set intervals, say once a year. With the threshold approach, you rebalance when a part drifts a set amount from the plan, say 5 percentage points. Many people combine the two: they look once or twice a year and only trade if the drift is large.
A study by a large US fund firm (2010) of US data from 1926 to 2009 found little difference in risk-adjusted returns between monthly, quarterly and annual rebalancing, but frequent rebalancing meant far more trades and costs. In the same study, a 60% share and 40% bond portfolio that was never rebalanced ended up about 98% in shares.
- Rebalancing with new money: if you use your monthly savings to buy only the part that has fallen behind, you often need to sell nothing, which keeps both costs and tax down.
Source: Vanguard Research, July 2010
See the numbers as a table
| Shares | Bonds | |
|---|---|---|
| At the start | 60 | 40 |
| Never rebalanced, at the end | 98 | 2 |
Keeping costs and tax in mind
Every sale costs a brokerage commission or other charges. Breaking an FDR or cashing a sanchayapatra early can cut the profit you receive. Large gains on selling shares can also bring tax on capital gains. So trading again and again over small drifts can cost more than rebalancing is worth.
Worked example
- Start with Tk 1,00,000: Tk 60,000 in shares, Tk 40,000 in fixed income. The plan is 60:40.
- Say that in a year shares rise 50% and fixed income 8%. Shares are now Tk 90,000 and fixed income Tk 43,200: Tk 1,33,200 in all. Shares are now about 68% of the total.
- If you rebalance: you sell about Tk 10,080 of shares and put it into fixed income. Shares Tk 79,920, fixed income Tk 53,280: back to 60:40.
- The next year shares fall 30% (for simplicity, fixed income is left unchanged). Without rebalancing you have Tk 1,06,200; with rebalancing, Tk 1,09,224.
Result: the rebalanced portfolio fell less, because its risk stayed as planned. But if shares had kept rising, not rebalancing would have earned more. Rebalancing is a habit for controlling risk, not a trick for higher returns. Costs and tax are left out here; the numbers are only an example.
Common mistakes
- Treating rebalancing as a way to earn extra. Its main job is to keep risk within your plan.
- Never doing it, then discovering in a big fall that the portfolio had become far riskier than intended.
- Doing it too often, so commissions, early-withdrawal penalties and tax eat up the benefit.
- Breaking the rule because the news says “shares will rise further”. At that point it is no longer rebalancing but guessing.
Set a mix, check it once or twice a year, and return to plan when it drifts too far: rebalancing keeps your risk under your control.