Rebalancing is a good practice to be done when there is abnormal gains or losses in a particular stock or a group of stocks in a portfolio. Rebalancing helps book profits and average cost.
A portfolio consists of number of stocks with each stock having a specific weight according to the respective expected performance in the future, weight in the index, liquidity and market capitalization. For example, if a particular stock in a particular sector is expected to outperform other stocks in the portfolio then it is given a higher weight in comparison to others as it would contribute largely to the performance going forward.
Over a period of time the portfolio value increases or decreases depending on the weighted average performance of stocks in it. The assigned weights can change over a period of time as some of the stocks increase in value contributing to the rise in the portfolio value while other stocks either stay at the same level or decrease in value contributing to the decline in overall value of the portfolio. The net increase or decrease in the value depends on the overall performance of the portfolio.
Portfolio rebalancing can be explained as the process which brings back on track the objective of generating optimum returns from the portfolio in a sustained manner.
Rebalancing is the process of buying and selling stocks in the portfolio in order to set the weight of each asset class back to its original state. The mix of stocks originally created by an investor inevitably changes as a result of differing returns among various stocks. As a result, the percentage that one has allocated to different stocks will change. This percentage allocation has to be brought back on track whenever the need arises as some of the stocks/stock have/has already increased in value and may not see significant upside in the near term or some of the stocks/stock have/has already decreased in value and may or may not see any recovery in the near term due to fundamental reasons.
Stocks in the portfolio are rebalanced to bring them back in the necessary proportion or as per the defined strategy of the portfolio.
For example, let us assume a portfolio has 10 stocks with equal weights of 10%. Let us assume that the total invested amount is Rs.1,00,000 and with the given weight of 10%, each stock is bought equal to Rs. 10,000 to form the complete portfolio.
Suppose after a specific time period only one stock has doubled in value and rest all have remained at the same level. To realign the weight of each stock in the portfolio to the same proportion as that in the beginning is called rebalancing. The weight of that stock (which has doubled) in the portfolio would be 18.18% (20,000/1,10,000) and other stocks would have a weight of 9.09% each to form the complete portfolio.
The requirement now is to reallocate the increased weight of the stock that has doubled in value to each of the other stocks to bring all of them back to 10% weight. For this the stock that has doubled in value has to be reduced to the extent so that it again has the original weight. The total value is now Rs.1,10,000 for the portfolio and to have 10% weight each for all stocks the amount in each of them has to be Rs. 11,000. The amount of Rs.9000 has to be reduced from the stock that has doubled in value and added to the remaining 9 stocks in the portfolio equally. This means Rs.1000 has to be added to each of the remaining 9 stocks in the portfolio.
This completes the rebalancing process for the time being and it will have to be done periodically if the need arises. When we say that the amount has to be reduced from one stock and reallocated to others it means we will have to sell some existing quantity of that stock (the one that has doubled in value) and add certain quantity to the existing other stocks (9 in the above example) in equal proportion to the price at that point of time.