Portfolio Rebalancing
Definition
The process of realigning the weightings of assets in a portfolio by periodically buying or selling to maintain your target asset allocation and risk level.
Rebalancing is the maintenance task that keeps your portfolio aligned with your investment plan. As markets move, your carefully chosen asset allocation drifts — stocks outperforming bonds might shift a 60/40 portfolio to 70/30, taking on more risk than intended. Rebalancing sells some of the outperformers and buys the underperformers to restore the target.
There are two main rebalancing approaches: calendar-based (rebalancing at fixed intervals like quarterly or annually) and threshold-based (rebalancing when any asset class drifts beyond a set percentage, like 5%, from its target). Threshold-based rebalancing is more responsive to market moves but requires more monitoring.
Rebalancing has a counterintuitive benefit: it forces you to systematically "buy low, sell high." When stocks surge and become overweighted, rebalancing sells some stocks (high) and buys bonds (low). When stocks crash and become underweighted, rebalancing buys stocks (low) and sells bonds (high).
Tax-efficient rebalancing is important in taxable accounts. Strategies include using new contributions to buy underweighted assets, rebalancing primarily within tax-advantaged accounts (IRAs, 401ks), using dividends and distributions to rebalance, and only selling lots with losses or minimal gains.
Over-rebalancing (too frequently) generates unnecessary transaction costs and taxes. Under-rebalancing (too infrequently) allows risk to drift significantly from your target. Annual or semi-annual rebalancing with a 5% drift threshold is a reasonable approach for most investors.
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Frequently Asked Questions
How often should I rebalance my portfolio?
Annual rebalancing is sufficient for most investors. Some use a threshold-based approach, rebalancing whenever an asset class drifts more than 5% from target. More frequent rebalancing rarely improves returns and can create tax drag in taxable accounts.
Does rebalancing improve returns?
Rebalancing's primary benefit is risk management, not return enhancement. It keeps your risk level consistent with your plan. In some scenarios, rebalancing slightly improves risk-adjusted returns by systematically buying low and selling high, but this isn't guaranteed.