Last Updated on October 11, 2024 at 1:31 pm
A reader says, “My equity allocation is 66%. My target allocation is 60%. But to rebalance, I must shift Rs. 48 Lakhs (approximately) from equity mutual funds to fixed-income instruments. The tax I must pay will be significant, and it bothers me. I invest almost Rs. 4L a month in my portfolio with almost 3L in equity. Can I invest Rs 3L in fixed income for the next few months instead of rebalancing?”
This may seem like a “rich guys” problem to many readers. However, it will affect long-term investors sooner or later. The best way to avoid this dilemma is to understand and appreciate why we need to rebalance a portfolio. Note: We answered this question in Aug 2024.
For those who wish to know the basics, we have a ton of articles on rebalancing:
- Portfolio Rebalancing: We answer FAQ investors worry about (part 1)
- Portfolio Rebalancing FAQ Part 2
- Portfolio Rebalancing FAQ Part 3
If you do not rebalance a portfolio and let market forces decide its asset allocation, you are leaving the fate of your financial goals to luck. This is like trying to water a garden with an unmanned water hose.
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By periodically resetting your asset allocation, you are controlling the volatility of your overall portfolio and how much its return fluctuates. You ensure your actual corpus stays close to the expected corpus. There is no need to rebalance each year. You can do so once there is a deviation of 5% from your target allocation. This will minimise tax and exit load outgo.
For those who appreciate numbers: Forget tax and exit loads, this is why your portfolio should be rebalanced each year.
Rebalancing should ideally be done over a few days. So you redeem from the over-weight asset class in one-shot and invest in the under-weight asset in one-shot.
You are worried about paying a 12.5% tax on the capital gains associated with a Rs. 48 Lakh redemption*. What if you did not rebalance and the market corrected significantly or did not move anywhere for the next 12-15 months? You lose the gains that you have made, and that could be a lot more than the Rs. 6 lakhs tax.
* Thanks to Amol Joshi on X for correcting this statement.
This Rs. 6 lakh is the amount you will lose or gain in your portfolio over 1-3 days up or down movement. Look at it this way, and it seems a pittance (at least to me). What is more important, taking some money from an over-heated asset and transferring it to the comfort of fixed income or paying a small amount of tax? See, for example: Fearing tax, I didn’t rebalance my portfolio in Sep 2021 and now suffer higher losses!
The alternative – trying to “adjust” investment amounts to avoid paying taxes. In the present example, this could take more than a year. The market could significantly correct during this time, making it a case of penny foolish pound foolish. See: Can I rebalance my portfolio by adjusting my SIP amounts?
Look at the larger picture. You are a multi-crorepati. Stop worrying about a few lakhs lost to taxes and safeguard your portfolio. Rebalance now!