After a sustained bear or bull rally, as the asset allocation ratio deviates significantly from your intentions it is time to rebalance your portfolio.

The equity market has been in a secular bull run since March 2020. Some investors are feeling apprehensive about a potential correction, and wondering about what the right approach would be, from the perspective of partial profit booking or a little defensive approach. Balanced advantage funds of AMCs are receiving buoyant flows from investors, who are baulking at taking a higher equity exposure at this juncture.

Context
Your portfolio comprises various asset classes like equity, debt, gold, etc. The allocation ratio to various investment assets is decided as per your risk profile, time horizon, investment objectives, risk profile of the asset category, etc. Apart from these aspects, the allocation ratio serves as a powerful tool from a different perspective.

When you rebalance your portfolio and get back to your initially decided allocation ratio, you do purchases in a bear market and profit booking in a bull market. This is a discipline that prompts partial profit booking at higher valuations and prompts buying at cheaper valuations.

Illustration and action point
As an illustration, an investor follows an allocation ratio of 60:40, 60% in equity and 40% in fixed income. In the equity market correction phase of January to March 2020, the allocation to equity would have become palpably lower than 60% (post correction) and debt would have increased beyond 40% (due to correction in equity and accruals in debt). If the rebalancing was done in March 2020, he would have purchased that much equity to restore the balance. This would have resulted in purchases at lower prices.

Cut to the current context. Subsequent to the rally over the past one-and-half years, if the decided allocation is 60:40, the equity component would be higher than 60%. Whether correction happens or not, if you restore the balance, you would be booking partial profits. You cannot control the market, but by controlling your portfolio asset allocation, you would have some control on the potential volatility in your portfolio.

Rebalancing faces a psychological hurdle: shifting partially from a high return avenue (e.g., this is giving me 15% return over a long horizon) to a low return avenue (e.g. expectation from debt is only 6% now). On the other side, when the market is bottoming, one tends to hold on (it will become even cheaper after a few days, I will buy then). This is where you have to separate your emotions from your financial investments.

Conclusion
The rationale for doing this is not to run after the highest-return investment avenue, as returns from the various categories vary every year, every market cycle. The rationale is, your portfolio should give you the optimum result, adjusted for volatility. That is, your journey should be relatively smooth. Trying to predict the level of markets is futile; what is in your control is the portfolio you construct, to suit your objectives.
The ratio of 60:40 mentioned above is only for illustration; the longer your horizon, the higher can be the allocation to equity—provided you don’t worry about the potholes on the road, i.e., volatility. The point of time at which you should do the rebalancing cannot be defined; when there is a sustained bear or bull rally and the ratio has deviated significantly from your intentions, it is time to do it.

Source: https://www.financialexpress.com/money/equity-investing-when-should-you-rebalance-your-portfolio/2351222/