Most investors spend a great deal of thought on choosing an asset allocation, the split between equity, debt and gold that suits their goals and their tolerance for risk. Far fewer give the same attention to keeping that allocation in place. Yet markets do not move in step, and within a year or two a carefully chosen mix can look quite different from what was intended. Rebalancing is the discipline of bringing it back.
Why a portfolio drifts
Consider an investor who starts with ₹10 lakh split 60:40 between equity and debt: ₹6 lakh in equity funds and ₹4 lakh in debt. Suppose equity then rises 30% in a strong year while debt earns 7%. The equity portion grows to ₹7.80 lakh and the debt portion to ₹4.28 lakh, for a total of ₹12.08 lakh.
The portfolio is now about 65% equity and 35% debt. Nothing was bought or sold, yet the investor is carrying more risk than they chose. If markets fall sharply the following year, the loss will be larger than their plan allowed for. To return to 60:40, they would need to move roughly ₹55,000 from equity to debt.
The reverse happens after a fall. Equity shrinks as a share of the portfolio, and the investor ends up under-invested in equity at exactly the time when prices are lower.
What rebalancing actually achieves
- It keeps risk where you set it. Your allocation was chosen for your age, goals and temperament. Rebalancing stops the market from changing it for you.
- It enforces buying low and selling high. You trim the asset that has done well and add to the one that has lagged. This is the opposite of what emotion usually suggests.
- It removes guesswork. A rule-based approach means you do not have to predict where markets are heading.
Rebalancing is not designed to maximise returns in every period. In a long bull market, a portfolio left to drift would have earned more. Its purpose is to keep the journey within limits you can live with, so that you stay invested through difficult years.
Three ways to decide when to rebalance
1. Calendar rebalancing
Review the portfolio on a fixed date, once a year for most people, and restore the target mix. Choosing a memorable date, such as your birthday or the start of the financial year in April, makes the habit easier to keep. Annual reviews are frequent enough to control drift and infrequent enough to limit tax and transaction costs.
2. Threshold rebalancing
Act only when an asset class moves more than a set margin from its target, commonly five percentage points. With a 60% equity target, you would rebalance if equity rose above 65% or fell below 55%. This responds to large market moves and ignores minor fluctuations.
3. A combination of both
Check once a year, but act only if the drift exceeds your threshold. For most individual investors, this combined approach strikes the best balance between discipline and cost.
How to rebalance without unnecessary tax
Selling investments to rebalance can trigger capital gains tax and, for recent mutual fund purchases, exit loads. Under the rules applicable for Tax Year 2026-27, which Budget 2026 left unchanged, long-term gains on equity shares and equity mutual funds held for more than 12 months are taxed at 12.5% on the portion above ₹1.25 lakh in a year, while short-term equity gains are taxed at 20%. There are several ways to reduce this cost.
- Redirect new money first. If equity is overweight, send your next few months of SIPs or fresh savings to debt instead. This corrects the mix without selling anything.
- Sell units held for more than 12 months. Long-term equity gains are taxed at a lower rate than short-term gains, and the first ₹1.25 lakh each year is exempt.
- Use the annual exemption. Where possible, time rebalancing sales so that long-term equity gains stay within the ₹1.25 lakh limit for the year.
- Check exit loads. Many equity funds charge an exit load, often 1%, on units redeemed within a year of purchase. Redeem older units first.
- Rebalance within a family’s combined portfolio. If a spouse has unused long-term gain exemption, sales in their name may carry less tax, provided the investments are genuinely theirs.
Rebalancing as goals approach
Rebalancing to a fixed mix is only part of the picture. As a goal such as a child’s education or retirement comes closer, the target itself should change. Three to five years before you need the money, begin shifting gradually from equity towards debt, so that a market fall in the final years cannot derail the plan. This is sometimes called a glide path. The annual review is the natural moment to adjust it.
Common mistakes to avoid
- Rebalancing too often, which raises costs without improving outcomes.
- Abandoning the plan after a strong rally because selling winners feels wrong.
- Looking at each fund in isolation instead of the whole portfolio, including PPF, EPF and fixed deposits, which count towards your debt allocation.
- Ignoring tax and exit loads when deciding which units to sell.
The takeaway
Choose an allocation that suits you, write down your target and your threshold, and review once a year. Correct the drift first with new money, and sell only where necessary, using long-term units and the annual exemption to keep tax low. Rebalancing is unremarkable in any single year, but over a lifetime of investing it is one of the habits that most reliably keeps a plan on course.
This article is for general information only and does not constitute investment or tax advice. Tax rules can change; please consult a qualified adviser before acting on your specific circumstances.
