Portfolio rebalancing is the process of periodically buying and selling assets to maintain your target allocation. It enforces investment discipline and manages risk as markets move.
Beginner
What It Means
As different investments rise and fall at different rates, your portfolio drifts from its original allocation. Rebalancing brings it back to target by selling what’s grown and buying what’s lagged.
Portfolio Example
Starting Allocation (60/40):
- Stocks: $60,000 (60%)
- Bonds: $40,000 (40%)
After Stocks Rally (+25%):
- Stocks: $75,000 (65%)
- Bonds: $40,000 (35%)
Rebalancing Action:
- Sell $5,750 in stocks
- Buy $5,750 in bonds
- Back to 60/40 split
Why It Matters
Rebalancing serves two critical purposes:
- Risk Control: Prevents your portfolio from becoming riskier than intended
- Buy Low, Sell High: Systematically sells winners and buys laggards
Without rebalancing, a 60/40 portfolio could become 80/20 after a bull market - much riskier than intended.
Advanced
Rebalancing Approaches
| Approach | How It Works | Pros | Cons |
|---|
| Calendar | Rebalance on fixed schedule (monthly, quarterly, annually) | Simple, predictable | May trade unnecessarily or miss large drifts |
| Threshold | Rebalance when allocation drifts beyond bands (e.g., 5%) | Trades only when needed | Requires monitoring |
| Hybrid | Check on calendar, trade only if beyond threshold | Best of both | Slightly more complex |
Rebalancing Frequency Trade-offs
| Frequency | Benefits | Drawbacks |
|---|
| Daily | Tight control | High costs, tax inefficient |
| Monthly | Good control | Moderate costs |
| Quarterly | Balance of control and cost | Industry standard |
| Annually | Low costs, tax efficient | Large drifts possible |
Research suggests rebalancing frequency matters less than consistently having a rebalancing policy. Quarterly or annual rebalancing captures most of the benefit.
The Rebalancing Bonus
Rebalancing can add returns in range-bound markets:
Example: Two uncorrelated assets, both with 0% return over time
- Without rebalancing: 0% return
- With rebalancing: ~0.5-1% annual "bonus"
Why? Systematically selling high and buying low
The rebalancing bonus disappears or becomes negative in strongly trending markets. If stocks consistently outperform, rebalancing hurts by selling winners.
Tax-Efficient Rebalancing
| Strategy | Description |
|---|
| Tax-Loss Harvesting | Sell losers first to realize losses |
| Asset Location | Rebalance within tax-advantaged accounts first |
| New Contributions | Direct new money to underweight assets |
| Withdrawals | Take distributions from overweight assets |
| Dividend Reinvestment | Direct dividends to underweight assets |
Threshold Bands
Common threshold approaches:
| Method | Example | Description |
|---|
| Absolute | 5% | Rebalance if more than 5 percentage points from target |
| Relative | 25% | Rebalance if more than 25% away from target weight |
| Volatility-Adjusted | Varies | Tighter bands for more volatile assets |
Example (60% stock target):
- Absolute 5%: Rebalance below 55% or above 65%
- Relative 25%: Rebalance below 45% or above 75%
Costs of Rebalancing
| Cost Type | Description |
|---|
| Transaction Costs | Commissions, bid-ask spreads |
| Market Impact | Price movement from large trades |
| Taxes | Capital gains on sales |
| Opportunity Cost | May sell assets that continue rising |
Rebalancing in Practice
Considerations:
- Use threshold bands (3-5%) rather than rigid calendar
- Rebalance within tax-advantaged accounts first
- Use new contributions to rebalance passively
- Consider tax-loss harvesting opportunities
- Don’t over-optimize - any consistent approach works
Behavioral Benefits
Beyond financial benefits, rebalancing provides:
- Discipline: Forces systematic decision-making
- Emotional Buffer: Removes emotion from buy/sell decisions
- Risk Awareness: Regular check-in on portfolio risk
When NOT to Rebalance
| Situation | Consideration |
|---|
| Small drifts (under 2%) | Transaction costs may exceed benefit |
| Short-term holdings | Tax implications may outweigh benefits |
| Strong trends | May want to let winners run |
| High transaction costs | Threshold should be wider |
