Portfolio Rebalancing Guide: When and How to Rebalance

Published: January 22, 2025 Category: Portfolio Management Author: Education Team

Portfolio rebalancing is the process of realigning your investment portfolio back to your target asset allocation. Over time, market movements cause your portfolio to drift from your original allocation, and rebalancing helps maintain your desired risk level and investment strategy.

What is Portfolio Rebalancing?

Rebalancing involves buying and selling assets to restore your portfolio to its target allocation. For example, if your target is 60% stocks and 40% bonds, but stocks have performed well and now represent 70% of your portfolio, you would sell some stocks and buy bonds to return to 60/40.

                    Key Concept: Rebalancing forces you to "sell high and buy low" by taking profits from outperforming assets and adding to underperforming ones, which can improve long-term returns.
                

Why Rebalance?

1. Maintain Risk Level

Your risk tolerance determines your target allocation. As allocations drift, your risk level changes. Rebalancing keeps risk aligned with your goals.

2. Lock in Gains

Selling portions of winning investments locks in profits and prevents over-concentration in hot assets.

3. Buy Low Opportunities

Adding to underperforming assets when they're relatively cheap can improve long-term returns.

4. Stay Disciplined

Rebalancing enforces a systematic approach, reducing emotional decision-making.

When to Rebalance

There are several approaches to timing rebalancing:

1. Time-Based Rebalancing

Rebalance on a fixed schedule:

Quarterly: Every 3 months
Semi-Annually: Every 6 months
Annually: Once per year (most common)

Pros: Simple, systematic, removes emotion

Cons: May rebalance when not needed, or miss needed rebalancing

2. Threshold-Based Rebalancing

Rebalance when allocations drift by a set amount:

When any asset class moves 5% from target
When major allocation (stocks vs bonds) moves 10%

Pros: Only rebalances when needed

Cons: Requires more monitoring

3. Hybrid Approach

Check allocations quarterly or semi-annually, but only rebalance if thresholds are exceeded.

Best Practice: Most investors find annual rebalancing with threshold checks works well. Review quarterly, rebalance annually or when thresholds are exceeded.

How to Rebalance

Step 1: Calculate Current Allocation

Determine what percentage each asset class represents:

Total portfolio value
Value of each asset class
Current percentages

Step 2: Compare to Target Allocation

Identify which assets are overweight (above target) and underweight (below target).

Step 3: Determine Rebalancing Actions

Calculate how much to buy or sell:

Sell overweight positions
Buy underweight positions
Consider tax implications

Step 4: Execute Trades

Make the necessary trades to restore target allocation.

Rebalancing Methods

1. Sell and Buy

Sell overweight assets and buy underweight assets. Most straightforward method.

2. New Contributions

Direct new investments to underweight assets. Avoids selling and potential taxes.

3. Dividend Reinvestment

Reinvest dividends into underweight assets instead of automatically reinvesting in the same asset.

4. Withdrawals

When withdrawing money, take it from overweight assets to help rebalance.

Tax Consideration: In taxable accounts, selling can trigger capital gains taxes. Consider using new contributions or withdrawals to rebalance when possible to minimize taxes.

Rebalancing Example

Target allocation: 60% stocks, 30% bonds, 10% cash

Current allocation: 70% stocks, 25% bonds, 5% cash

Portfolio value: $100,000

Actions needed:

Sell $10,000 of stocks (reduce from $70,000 to $60,000)
Buy $5,000 of bonds (increase from $25,000 to $30,000)
Add $5,000 to cash (increase from $5,000 to $10,000)

Common Rebalancing Scenarios

Stocks Outperforming

If stocks have done well and are now overweight:

Sell some stocks
Buy bonds or other underweight assets
Lock in stock gains

Bonds Outperforming

If bonds have done well:

Sell some bonds
Buy stocks or other underweight assets
Maintain growth exposure

One Sector Outperforming

If technology stocks have grown to dominate your portfolio:

Reduce technology exposure
Add to other sectors
Maintain diversification

Tax Considerations

Rebalancing in taxable accounts can trigger taxes:

Tax-Efficient Rebalancing

Use new contributions to rebalance when possible
Rebalance in tax-advantaged accounts (IRAs, 401(k)s) first
Consider tax-loss harvesting
Use withdrawals from overweight positions
Wait for long-term capital gains treatment (hold 1+ year)

Tax-Advantaged Accounts

In IRAs and 401(k)s, you can rebalance without immediate tax consequences, making rebalancing easier and more frequent.

Common Mistakes to Avoid

Over-Rebalancing: Too frequent rebalancing increases costs and taxes
Under-Rebalancing: Letting allocations drift too far increases risk
Ignoring Taxes: Not considering tax implications in taxable accounts
Emotional Decisions: Letting market sentiment override rebalancing plan
No Plan: Not having a clear rebalancing strategy
Transaction Costs: Rebalancing too frequently in accounts with fees

Rebalancing Frequency Guidelines

Recommended frequencies:

Aggressive Growth Portfolio: Quarterly or semi-annually
Balanced Portfolio: Annually
Conservative Portfolio: Annually or every 2 years
Retirement Accounts: Can rebalance more frequently (no tax impact)
Taxable Accounts: Less frequently to minimize taxes

Automated Rebalancing

Many platforms offer automated rebalancing:

Robo-advisors automatically rebalance
Some brokerages offer automatic rebalancing
Target-date funds rebalance automatically
ETFs can help maintain allocations

Automation Tip: Automated rebalancing removes emotion and ensures consistency, but review your allocations periodically to ensure they still match your goals.

When NOT to Rebalance

Sometimes it's better to wait:

Short-term market volatility (wait for stability)
Large transaction costs would eat into returns
Tax consequences outweigh benefits
Allocation drift is minimal (within 2-3%)
You're about to make large contributions or withdrawals

Monitoring Your Portfolio

Regular monitoring helps with rebalancing:

Review allocations quarterly
Track performance relative to targets
Note when thresholds are exceeded
Plan rebalancing actions
Consider tax implications

Conclusion

Portfolio rebalancing is an essential discipline for maintaining your investment strategy and risk level. While it may seem counterintuitive to sell winners and buy laggards, this systematic approach can improve long-term returns and help you stay on track with your financial goals. The key is finding a rebalancing frequency and method that works for your situation while minimizing costs and taxes.

This educational content is for informational purposes only. Rebalancing strategies should be tailored to individual circumstances, including tax situation and investment goals. Consult with a qualified financial advisor for personalized rebalancing recommendations.