When and How to Rebalance Your Portfolio: Complete Guide

Portfolio rebalancing is one of the most important yet often overlooked aspects of investing. When your investments grow at different rates, your portfolio drifts away from your intended allocation. Rebalancing brings it back in line. In this guide, we will explain everything you need to know about rebalancing your investment portfolio.

What is Portfolio Rebalancing?

Portfolio rebalancing is the process of realigning the weightings of assets in your portfolio to match your original target allocation. Over time, some investments will outperform others, causing your portfolio to become unbalanced. Rebalancing involves selling some of your winners and buying more of the underperformers to restore your target mix.

Why Rebalancing is Important

Maintains Your Risk Level

Your target allocation reflects your risk tolerance. When stocks outperform, your portfolio becomes riskier. When bonds outperform, it becomes too conservative. Rebalancing keeps your risk where you want it.

Forces Disciplined Investing

Rebalancing naturally implements "buy low, sell high" because you sell what has risen and buy what has fallen. This removes emotion from investing decisions.

Can Improve Returns

Studies show that disciplined rebalancing can add 0.5% to 1% to annual returns over time. This comes from systematically harvesting gains and buying assets when they are relatively cheap.

Rebalancing Strategies

1. Calendar Rebalancing

With this method, you rebalance on a set schedule, such as quarterly, semi-annually, or annually. This is the simplest approach and works well for most investors.

• Pros: Simple, predictable, easy to remember
• Cons: May rebalance when not needed, may miss extreme drift between periods

2. Threshold Rebalancing

You rebalance whenever any asset class drifts beyond a set threshold, such as 5% or 10% from its target. For example, if your target is 60% stocks and you rebalance at 5%, you would act when stocks reach 65% or 55%.

• Pros: Only rebalances when needed, responds to market movements
• Cons: Requires more monitoring, may trigger frequently in volatile markets

3. Combination Approach

Many investors combine both methods. They check their portfolio on a schedule (quarterly) and only rebalance if an asset class has drifted beyond their threshold (5%). This balances simplicity with efficiency.

When to Rebalance Your Portfolio

Best Times to Rebalance

• At regular intervals: Quarterly or annually works for most people
• After major market moves: When markets swing 15-20% in either direction
• When life circumstances change: New job, marriage, retirement approaching
• When making contributions: Use new money to buy underweighted assets

Signs You Need to Rebalance

• Any asset class is more than 5% from its target
• You have not rebalanced in over a year
• Your risk tolerance has changed
• Your time horizon has shortened significantly

How to Rebalance Your Portfolio

Method 1: Sell and Buy

The traditional method is to sell overweighted assets and use the proceeds to buy underweighted ones. This is direct but can trigger taxes in taxable accounts.

Method 2: Direct New Contributions

Instead of selling, direct new contributions to underweighted asset classes. This achieves rebalancing over time without selling and triggering taxes.

Method 3: Redirect Dividends and Interest

Instead of reinvesting dividends in the same fund, direct them to underweighted assets. This is a tax-efficient way to gradually rebalance.

Method 4: Rebalance in Tax-Advantaged Accounts

Do your selling in 401(k)s and IRAs where there are no tax consequences. Keep taxable accounts stable to avoid capital gains taxes.

How Often Should You Rebalance?

Research suggests that annual or semi-annual rebalancing works best for most investors. More frequent rebalancing can increase trading costs and taxes without improving returns. Less frequent rebalancing may allow too much drift.

• Monthly: Too frequent, high costs, minimal benefit
• Quarterly: Good for active investors with threshold triggers
• Semi-annually: Good balance of monitoring and efficiency
• Annually: Simple and effective for most long-term investors

Common Rebalancing Mistakes

1. Ignoring Taxes

Selling winners in taxable accounts creates capital gains taxes. Always consider the tax impact and use tax-efficient methods when possible.

2. Over-Rebalancing

Rebalancing monthly or after every small move creates unnecessary costs. Stick to a schedule or threshold and do not react to small changes.

3. Ignoring Transaction Costs

Even with commission-free trading, there are bid-ask spreads and potential market impact. Make sure the rebalancing benefit exceeds the costs.

4. Being Too Precise

You do not need to hit exact targets. Being within 1-2% of your target is fine. Do not make tiny trades to achieve perfect precision.

5. Rebalancing During Panic

The worst time to rebalance is during a market crash when you are emotional. Stick to your predetermined schedule or thresholds.

Rebalancing Across Multiple Accounts

Many investors have multiple accounts: 401(k), IRA, taxable brokerage, etc. You should think about your asset allocation across all accounts, not within each one separately.

• Hold tax-inefficient assets (bonds, REITs) in tax-advantaged accounts
• Hold tax-efficient assets (index funds, growth stocks) in taxable accounts
• Calculate your total allocation across all accounts
• Rebalance by shifting within tax-advantaged accounts when possible

Summary

Portfolio rebalancing is essential for maintaining your target risk level and can improve long-term returns. Choose a strategy that fits your situation - calendar-based, threshold-based, or a combination. Rebalance at least annually, and use tax-efficient methods like directing new contributions to underweighted assets. The key is having a plan and sticking to it.

Ready to learn more? Check out our guide on asset allocation basics or learn about modern portfolio theory.