This article was written by Christine Benz, Morningstar's director of personal finance, for morningstar.com. It has been edited for an Indian audience.
If you've put off rebalancing because the process seems daunting to you, read on. The following step-by-step guide simplifies the task using some tools on Morningstar.in.
1) Determine your asset allocation targets
Your first step in the rebalancing process is to make sure you have an asset allocation framework.
If you had a stock/bond target that made sense for you before the recent market downturn or upturn, it should still fit now. And if you don't have an asset-allocation plan, it's time to make sure you have one.
There are no one-size-fits-all asset-allocation solutions. The years to retire and the expected length of retirement would differ between individuals, sources of in-retirement income would vary, and so on and so forth. A good idea would be to talk to a financial planner or adviser.
2) Find your current asset allocation
After you've determined what your optimal asset allocation should be, it's time to take a look at where you are now. Gather up your recent investment statements or go online for an even more current view of your portfolio, then take note of your current asset allocation.
Keeping track of your portfolio's asset allocation by hand can be a bit cumbersome and inexact, particularly because most funds aren't pure stock or bond investments. It's not uncommon for stock funds to hold double-digit cash stakes, for example. A balanced fund will have a significant allocation to debt.
For the clearest possible read on your asset allocation, I recommend the Morningstar X-Ray tool, which drills into each of your fund holdings to determine how they're allocated by asset class and investment style. If you store a portfolio on the website, simply click on the X-Ray tab view within Portfolio Manager to see your current split among cash, stocks, bonds, and other.
After completing the X-Ray, take note of your current asset allocation and compare that with your asset-allocation targets.. Determine where you need to add and subtract to restore your portfolio to your target levels.
3) Formulate a rebalancing plan
If your portfolio is in line with your target asset allocation and you're not making any inadvertent style or sector bets, your work is done.
Most likely, however, your analysis of your current asset allocation versus your targets indicates that changes are in order.
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When it comes to deciding which securities to add, as well as how much to add to each, you'll probably find that the process of overhauling your portfolio is a matter of trial and error. Here again, I'd recommend Morningstar's X-Ray tool, to help you evaluate the impact of various holdings on your asset-allocation mix before you decide to buy. Your stock portfolio doesn't need to be an exact clone of the broad market, but you should at least be aware of whether your portfolio is skewing heavily to one style or sector.
In some cases, the alterations you need to make are obvious--if you're heavy on bonds, for example, adding to stocks should resolve the problem. Getting to the bottom of other bets might take a little more research. For example, if your portfolio has more cash than you want it to, that could be because one of your equity-fund managers is holding a lot of cash. You could decide to live with it, and reduce your designated cash holdings accordingly, or else pare back your holdings in the cash-heavy equity fund.
Alternatively, you could try to correct your portfolio's imbalances not by selling but by directing a bigger share of future contributions to those holdings that need beefing up.
4) Keep the tax angle in mind
Before you begin altering your portfolio to put your asset allocation back in line with your targets, you also want to look at the tax impact of selling. It always pays to consider tax consequences when rebalancing.
Take capital gains into account. In the case of equity funds, ensure that you do not sell the units less than a year of holding. That way, you avoid short-term capital gains tax. If you have been doing an SIP, all you have to do is sell the units that were purchased a year earlier.
Non-equity funds qualify as debt funds for the purpose of taxation. So this would include all types of debt funds, international funds, monthly income plans (MIPs), and Gold exchange traded funds (ETFs).
Short-term capital gains would be levied if the holding period is less than 3 years. Short-term capital gains are added to the income and taxed as per the individual's income tax slab. If you sell the fund after holding it for a period of 36 months, or 3 years, it qualifies as long-term capital gains. This is 20% with indexation.
5) Make a habit of it
There are two ways to rebalance--either you can rebalance on a set schedule, say, every December, or you can rebalance whenever your portfolio gets dramatically out of whack with your targets. My advice is to split the difference. While I think it makes sense to give your portfolio a thorough review once a year, you don't want to get into the habit of trading too frequently. Schedule a top-to-bottom portfolio review at a fixed time each year, but rebalance only if your portfolio's allocations have got dramatically out of whack with your targets.
