Rebalancing

Rebalancing is the process of realigning your portfolio back to your target asset allocation by buying and selling investments. It's a disciplined approach to maintaining your desired risk level and can improve long-term returns.

What Is Rebalancing?

The Concept

Target Allocation - Your desired mix of stocks, bonds, and other assets
Market Movements - Cause your allocation to drift over time
Rebalancing - Sells winners, buys losers to restore target
Discipline - Maintains your risk profile

Why It's Needed

Stocks Outperform - Portfolio becomes stock-heavy over time
Risk Increases - More stocks = more volatility
Drift Happens - Without rebalancing, allocation changes
Restore Balance - Bring portfolio back to target

How Rebalancing Works

Example Scenario

Target Allocation:

60% stocks
40% bonds

After Market Gains:

Stocks up 20%, bonds up 5%
Portfolio now: 65% stocks, 35% bonds

Rebalancing Action:

Sell 5% of stocks
Buy 5% more bonds
Restore 60/40 allocation

The Counter-Intuitive Part

Sell Winners - Stocks that performed well
Buy Losers - Bonds that underperformed
Feels Wrong - But maintains discipline
Long-Term Benefit - Improves risk-adjusted returns

Why Rebalance?

Maintain Risk Profile

Target Risk - You chose allocation for good reasons
Drift Changes Risk - More stocks = higher risk
Restore Control - Rebalancing maintains intended risk
Sleep Better - Appropriate risk for your situation

Improve Returns

Buy Low, Sell High - Rebalancing does this automatically
Mean Reversion - Assets tend to revert to averages
Discipline - Forces you to take profits and buy dips
Studies Show - Rebalancing can add 0.5-1% annually

Reduce Volatility

Control Risk - Prevents portfolio from becoming too risky
Smoother Ride - Less volatility over time
Stay Invested - Less likely to panic during downturns
Better Experience - Easier to stick with plan

Example: Portfolio Allocation Over Time

The chart below shows how a portfolio allocation might change over time with automatic rebalancing during retirement. Notice how the allocation maintains a consistent target across different asset classes:

Rebalancing Strategies

Time-Based Rebalancing

Annual Rebalancing

Review and rebalance once per year
Simple and easy to remember
May miss opportunities between reviews
Good for most investors

Quarterly/Semi-Annual

More frequent adjustments
Closer to target allocation
More trading (costs and taxes)
May be overkill for most

Threshold-Based Rebalancing

5% Rule

Rebalance when allocation drifts 5% from target
Example: 60% target, rebalance if stocks hit 65% or 55%
More responsive to market movements
Can reduce unnecessary trading

Tighter Thresholds

3% or even 2% drift triggers rebalancing
More precise control
More frequent trading

Hybrid Approach

Time Check - Review quarterly or annually
Threshold Check - Rebalance if drift exceeds threshold
Best of Both - Combines simplicity with responsiveness
Flexible - Adapts to market conditions

Rebalancing Methods

Sell High, Buy Low

Sell Appreciated Assets - Take profits from winners
Buy Depressed Assets - Add to underperformers
Classic Rebalancing - Most common method
Tax Implications - May trigger capital gains

New Contributions

Direct New Money - To underweighted assets
Avoid Selling - No tax consequences
Gradual Rebalancing - Over time with contributions
Ideal Method - If you're still contributing

Withdrawals

Sell from Overweighted Assets - When withdrawing
Natural Rebalancing - As you take money out
Tax Efficient - Can manage tax impact
Retirement Strategy - Useful for retirees

Tax Considerations

Taxable Accounts

Capital Gains - Selling triggers taxes
Long-Term Gains - Preferable tax rates (if held >1 year)
Tax-Loss Harvesting - Offset gains with losses
Consider Threshold - May want wider bands to reduce trading

Tax-Advantaged Accounts

401(k), IRA - No tax consequences
Rebalance Freely - No tax impact
Ideal Location - For frequent rebalancing
Maximize - Use these accounts for rebalancing

Asset Location Strategy

Rebalance in Tax-Advantaged - Avoid taxable events
Taxable Accounts - Use new contributions or wider bands
Coordinate - Across all accounts
Tax Efficiency - Minimize tax drag

Common Rebalancing Mistakes

Not Rebalancing - Allocation drifts significantly
Rebalancing Too Often - Excessive costs and taxes
Emotional Rebalancing - Panic selling during downturns
Ignoring Costs - Trading fees and tax impact

Best Practices

Set Clear Rules

Written Plan - Define your rebalancing strategy
Stick to It - Don't deviate based on emotions
Review Periodically - Ensure strategy still makes sense
Automate When Possible - Remove emotion

Consider Your Situation

Age - Younger investors can rebalance less frequently
Tax Bracket - Higher brackets need more tax consideration
Account Types - Different strategies for taxable vs. tax-advantaged

Use Technology

Rebalancing Tools - Automated rebalancing on many platforms
Target-Date Funds - Automatically rebalance for you
Robo-Advisors - Handle rebalancing automatically

Rebalancing in Different Life Stages

Accumulation Phase

New Contributions - Use to rebalance
Less Frequent - Can let allocation drift more
Growth Focus - Slight overweight to stocks OK

Pre-Retirement

More Frequent - As you approach retirement
Risk Reduction - Gradually shift to bonds
Glide Path - Systematic reduction in stock allocation

Retirement

Withdrawal Strategy - Use withdrawals to rebalance
Maintain Allocation - Don't let it drift too much
Tax Management - Coordinate with tax planning

Rebalancing is a disciplined approach to maintaining your target asset allocation and managing portfolio risk. While it may feel counter-intuitive to sell winners and buy losers, it's a proven strategy that can improve risk-adjusted returns over time.

For most investors, annual rebalancing or threshold-based rebalancing (5% drift) provides a good balance of maintaining allocation without excessive trading. The key is having a plan and sticking to it, regardless of market conditions or emotions.