Portfolio rebalancing is the process of realigning your investment mix back to your target allocation. Over time, some investments grow faster than others, causing your portfolio to drift from its intended balance. Regular rebalancing keeps your risk level in check and can improve long-term returns.
Why Rebalancing Matters
Without rebalancing, your portfolio naturally drifts toward riskier assets:
- Stocks typically grow faster than bonds: A 60/40 portfolio can become 75/25 after a strong bull market
- Risk increases without you noticing: Your portfolio may be riskier than intended
- You may miss buying opportunities: Underperforming assets may be undervalued
- Emotional decisions take over: Without a system, you might chase winners or panic sell losers
Key principle: Rebalancing forces you to sell high and buy low systematically. You sell assets that have grown beyond their target weight and buy those that have fallen below.
When to Rebalance: Three Approaches
1. Calendar Rebalancing
Rebalance on a fixed schedule regardless of how much your portfolio has drifted:
- Annually: Most common, simple to remember (year-end or birthday)
- Semi-annually: Twice a year catches larger drifts
- Quarterly: More frequent but may increase trading costs
Pros: Simple, easy to automate, removes emotion
Cons: May rebalance unnecessarily or miss major drifts between dates
2. Threshold Rebalancing
Rebalance when any asset class drifts beyond a predetermined percentage from its target:
- 5% threshold: Rebalance when stocks drift from 60% to 65% or 55%
- 10% threshold: More relaxed approach, fewer transactions
- Relative threshold: Rebalance when an asset is 25% above or below its target weight
Pros: Responds to market conditions, rebalances only when needed
Cons: Requires monitoring, can trigger frequent trades in volatile markets
3. Hybrid Approach
Combine both methods for optimal results:
- Check portfolio quarterly or semi-annually
- Only rebalance if allocation has drifted 5% or more
- Best of both worlds: systematic but not excessive
How to Rebalance: Step by Step
Step 1: Review Your Current Allocation
- Calculate the current percentage of each asset class
- Compare to your target allocation
- Identify which assets are overweight and underweight
Step 2: Determine What Needs Adjustment
Example: Your target is 60% stocks, 40% bonds. Current allocation is 70% stocks, 30% bonds.
- Stocks are 10 percentage points overweight
- Bonds are 10 percentage points underweight
- Need to move money from stocks to bonds
Step 3: Choose Your Rebalancing Method
Method A: Sell and Buy
- Sell overweight assets
- Buy underweight assets with the proceeds
- Most direct approach but may trigger taxes in taxable accounts
Method B: Redirect New Contributions
- Direct new money to underweight assets
- No selling required, no tax implications
- Works well for accounts with regular contributions
Method C: Redirect Dividends and Interest
- Have dividends and interest flow to underweight areas
- Gradual rebalancing over time
- Combines well with other methods
Tax-Efficient Rebalancing
In taxable accounts, selling winners triggers capital gains taxes. Here are strategies to minimize the tax impact:
Rebalance in Tax-Advantaged Accounts First
- Do most rebalancing in IRAs and 401(k)s where there are no tax consequences
- Use taxable accounts only when necessary
Use New Contributions
- Direct new money to underweight assets
- Avoid selling and triggering gains
Tax-Loss Harvesting
- Sell losing positions to offset gains elsewhere
- Replace with similar (but not identical) investments
- Losses can offset gains and reduce taxes
Consider Asset Location
- Hold tax-inefficient assets (bonds) in tax-advantaged accounts
- Hold tax-efficient assets (index funds) in taxable accounts
- Reduces overall rebalancing tax burden
Rebalancing Costs to Consider
- Trading commissions: Many brokers now offer free trades, but check yours
- Bid-ask spreads: Small cost on each trade, adds up
- Capital gains taxes: The biggest cost in taxable accounts
- Time and attention: Your time has value too
Common Rebalancing Mistakes
- Rebalancing too often: Daily or weekly rebalancing creates unnecessary costs
- Never rebalancing: Letting winners run indefinitely increases risk
- Emotional rebalancing: Rebalancing based on fear or greed instead of targets
- Ignoring tax consequences: Generating large tax bills by rebalancing in taxable accounts
- Forgetting about all accounts: Consider your entire portfolio across all accounts
Automated Rebalancing Options
Several tools can automate the rebalancing process:
- Target-date funds: Automatically rebalance within the fund
- Robo-advisors: Manage and rebalance your portfolio automatically
- 401(k) auto-rebalance: Many plans offer automatic quarterly rebalancing
- Portfolio tracking tools: Alert you when rebalancing is needed
Track Your Portfolio Drift
Pro Trader Dashboard monitors your allocation and shows when you need to rebalance.
Summary
Rebalancing is essential for maintaining your intended risk level and can boost returns by systematically buying low and selling high. Choose a rebalancing approach that fits your style, whether calendar-based, threshold-based, or a hybrid. Prioritize tax efficiency by rebalancing in tax-advantaged accounts and using new contributions when possible. Annual or semi-annual rebalancing with a 5% threshold is a solid approach for most investors.
Learn more: asset allocation guide and tax tips for traders.