Portfolio rebalancing is one of the most important yet often overlooked aspects of successful investing. Over time, market movements cause your portfolio to drift away from your original allocation, potentially exposing you to more risk than intended. This guide explains everything you need to know about rebalancing your investment portfolio.
What is Portfolio Rebalancing?
Portfolio rebalancing is the process of realigning your portfolio's asset allocation back to your target weights. As different investments grow at different rates, your portfolio naturally drifts from its original allocation. Rebalancing involves selling some of the better-performing assets and buying more of the underperforming ones to restore your desired balance.
Key concept: Rebalancing forces you to sell high and buy low systematically, which is the opposite of what most emotional investors do. This disciplined approach can improve your long-term returns while managing risk.
Why Rebalancing Matters
Without rebalancing, your portfolio can become dangerously concentrated in certain assets. Here is why this matters:
- Risk management: Prevents your portfolio from becoming too aggressive or too conservative
- Disciplined investing: Removes emotion from investment decisions
- Return optimization: Historically, rebalanced portfolios have shown better risk-adjusted returns
- Goal alignment: Keeps your investments aligned with your financial objectives
Example: Portfolio Drift
You start with a 60/40 stock/bond allocation. After a strong bull market:
- Stocks grew from $60,000 to $90,000
- Bonds grew from $40,000 to $45,000
- Your new allocation is 67/33, not 60/40
- You now have 7% more stock exposure than intended
To rebalance, you would sell $9,450 of stocks and buy bonds to restore the 60/40 split.
Rebalancing Strategies
1. Calendar Rebalancing
This is the simplest approach. You rebalance on a fixed schedule, such as quarterly, semi-annually, or annually. Many financial advisors recommend annual rebalancing as a good balance between maintaining allocation and minimizing transaction costs.
2. Threshold Rebalancing
You rebalance only when an asset class drifts beyond a certain percentage from its target. Common thresholds are 5% or 10%. For example, if your target stock allocation is 60%, you would rebalance when stocks exceed 65% or fall below 55%.
3. Hybrid Approach
Combine both methods by checking your portfolio at regular intervals but only rebalancing if the drift exceeds your threshold. This approach minimizes unnecessary trades while ensuring significant imbalances are corrected.
Example: Threshold Rebalancing in Action
Your target allocation: 60% stocks, 30% bonds, 10% alternatives
With a 5% threshold, you rebalance when:
- Stocks exceed 65% or fall below 55%
- Bonds exceed 35% or fall below 25%
- Alternatives exceed 15% or fall below 5%
How to Rebalance: Step by Step
- Review your current allocation: Calculate the current percentage of each asset class
- Compare to targets: Identify which assets are overweight and underweight
- Calculate the trades needed: Determine how much to sell and buy
- Consider tax implications: Evaluate if selling will trigger capital gains
- Execute the trades: Make the necessary purchases and sales
- Document the changes: Keep records for tax purposes and future reference
Tax-Efficient Rebalancing Strategies
Rebalancing can trigger taxable events if done in taxable accounts. Here are strategies to minimize the tax impact:
- Use tax-advantaged accounts: Rebalance within IRAs or 401(k)s where trades do not trigger taxes
- Direct new contributions: Instead of selling, direct new money to underweight asset classes
- Use dividends and interest: Reinvest income into underweight positions
- Tax-loss harvesting: Sell losing positions to offset gains from rebalancing
- Asset location: Keep frequently traded assets in tax-advantaged accounts
Common Rebalancing Mistakes
Avoid these common errors when rebalancing your portfolio:
- Rebalancing too frequently: This increases transaction costs and tax liability
- Ignoring transaction costs: Fees can eat into returns, especially for small accounts
- Emotional decision-making: Stick to your plan regardless of market conditions
- Forgetting about taxes: Always consider the tax impact before making trades
- Not rebalancing at all: Letting drift go unchecked can significantly increase risk
When to Review Your Target Allocation
Your target allocation itself should be reviewed when your life circumstances change:
- Major life events (marriage, children, inheritance)
- Significant changes in income or expenses
- Approaching retirement (typically shifting to more conservative allocation)
- Changes in risk tolerance
- Reaching financial milestones
Track Your Portfolio Allocation Automatically
Pro Trader Dashboard monitors your portfolio allocation in real-time and alerts you when rebalancing is needed. See exactly how your actual allocation compares to your targets.
Summary
Portfolio rebalancing is essential for maintaining your desired risk level and achieving your long-term investment goals. Choose a rebalancing strategy that fits your needs, whether calendar-based, threshold-based, or a combination of both. Remember to consider tax implications and transaction costs when executing trades. With a disciplined rebalancing approach, you can stay on track toward your financial objectives.
Want to learn more about portfolio management? Check out our guides on portfolio correlation and modern portfolio theory.