Portfolio Rebalancing 101: How and When to Rebalance Your Investments

Introduction

Portfolio rebalancing is the regular process of returning your investments to a chosen target mix of asset types (for example, stocks and bonds). It keeps your portfolio's risk and potential return in line with the plan you set when you started investing.

Rebalancing matters because markets move. Over time, one asset class may grow faster than another and change the share of your portfolio, unintentionally making it riskier or more conservative than you planned. This guide explains why rebalancing helps, common methods to do it, a simple step-by-step example, and practical tips for beginners.

What you'll learn: how to pick a rebalancing method, when to act, how to execute rebalancing trades, tax and cost considerations, and common mistakes to avoid.

Key Takeaways

• Rebalancing restores your target asset allocation and maintains the risk level you chose for your portfolio.
• Common methods are calendar-based (e.g., annually) and threshold-based (e.g., rebalance when an allocation drifts by 5%).
• Use cash flows (new contributions or withdrawals) to rebalance cheaply before buying or selling assets.
• Taxable accounts require extra caution, selling can create taxable events; prefer rebalancing in tax-advantaged accounts when possible.
• Automatic rebalancing via robo-advisors or broker tools removes emotion and simplifies the process.

Why Rebalancing Matters

Assets rarely maintain perfect proportions. A strong year for stocks can increase their share of your portfolio, increasing overall volatility and potential losses if the market reverses. By rebalancing you intentionally sell part of what did well and buy more of what lagged, keeping your risk profile consistent over time.

Rebalancing can also help enforce discipline: it forces the 'buy low, sell high' behavior that's difficult to do emotionally during market swings. Over long periods, staying close to your target allocation helps your plan perform as intended.

How Rebalancing Works: Methods and Tradeoffs

There are two primary approaches to rebalancing: calendar-based and threshold-based. Each has tradeoffs in terms of cost, frequency, and workload.

Calendar-Based Rebalancing

Calendar-based rebalancing uses regular intervals: monthly, quarterly, semiannual, or annual. This method is simple and easy to automate. Many advisors recommend annual rebalancing for long-term, buy-and-hold investors.

Pros: predictable, low administrative overhead, fits most retirement accounts. Cons: may rebalance unnecessarily when drift is small or miss larger drift that occurs soon after a date.

Threshold-Based Rebalancing

Threshold-based rebalancing triggers when an asset's share deviates from its target by a specified band (e.g., +/- 5 percentage points). For example, if your target for stocks is 60% and stocks rise to 66%, you would rebalance when your threshold is breached.

Pros: more responsive to market moves and can reduce unnecessary trades. Cons: requires monitoring and may lead to irregular rebalancing activity that can be harder to manage without tools.

Hybrid Approaches

Many investors use a hybrid method: check allocations on a schedule (quarterly or annually) but only rebalance if an asset class has drifted beyond a set threshold. This balances predictability and responsiveness.

A Simple Step-by-Step Example

Below is a practical example using simple numbers so you can see the math and the trades involved. We'll use a two-ETF portfolio: $VOO (U.S. stocks, representing 100% of stock allocation) and $BND (aggregate bonds, representing 100% of bond allocation).

1. Set the target allocation. Example: 60% stocks ($VOO) and 40% bonds ($BND).
2. Check current values. Suppose you invested $6,000 in $VOO and $4,000 in $BND at the start. Total = $10,000.
3. Market movement changes values. After a year $VOO grows to $8,000 and $BND falls to $3,600. New total = $11,600.
4. Calculate current allocations. Stocks = $8,000 / $11,600 = 68.97% (~69%). Bonds = $3,600 / $11,600 = 31.03% (~31%).
5. Compare to target. Stocks are 9 percentage points above target (69% vs 60%). If your threshold is 5%, you would rebalance because the drift is greater than 5%.
6. Compute target dollar amounts. For a total of $11,600: target stocks = 60% × $11,600 = $6,960; target bonds = 40% × $11,600 = $4,640.
7. Determine trades. You need to reduce stocks by $8,000 − $6,960 = $1,040 and increase bonds by $4,640 − $3,600 = $1,040. Execute a $1,040 sell of $VOO and a $1,040 buy of $BND.

After these trades your allocations return to the 60/40 target. This example assumes no transaction costs or taxes and is meant to show the mechanics of rebalancing.

Where to Rebalance: Account Types and Tax Considerations

Rebalancing can create taxable events if you sell assets in a taxable brokerage account. Selling holdings that have capital gains will usually trigger taxes based on how long you held the position (short-term vs long-term capital gains).

Practical rules of thumb:

• Prefer rebalancing inside tax-advantaged accounts (IRAs, 401(k)s) where trades are not taxed at the time of sale.
• In taxable accounts, use new contributions or dividends to buy the underweight asset instead of selling winners. This is a low-cost way to rebalance.
• When selling is necessary, consider tax-loss harvesting (selling losers to offset gains) or selling shares held long term to benefit from lower capital gains rates.

Practical Tips for Implementing Rebalancing

Keep rebalancing simple and consistent. Here are practical steps you can follow:

1. Decide your target allocation based on your goals, time horizon, and risk tolerance (for example, 70/30 for long-term growth, 50/50 for moderate risk).
2. Choose a rebalancing method that fits your lifestyle: calendar, threshold, or hybrid.
3. Set specific rules for taxable vs. tax-advantaged accounts. Use contributions and dividends first to rebalance tax-efficiently.
4. Automate when possible. Many brokerages and robo-advisors offer automatic rebalancing on a schedule or when thresholds are breached.
5. Track transaction costs. Frequent rebalancing can increase fees and slippage, which can erode returns, especially for small portfolios.

Using Cash Flows to Rebalance

One of the easiest and cheapest ways to rebalance is to direct new contributions to the underweight asset. For example, if your 60/40 portfolio drifts to 70/30, direct your new deposit entirely to bonds until allocations return close to target.

This method avoids trading winners and can be particularly effective for ongoing retirement contributions.

Real-World Examples and Scenarios

Example 1, Young investor: A 30-year-old has a target 90% stocks / 10% bonds allocation in a tax-advantaged account. If $AAPL, $MSFT, and $NVDA outperform, the stock share may rise to 95%. Because the account is tax-advantaged, the investor rebalances annually and brings the allocation back to 90/10 by selling a portion of stocks and buying bonds.

Example 2, Near-retiree: A 60-year-old with a 60/40 allocation in both taxable and tax-deferred accounts finds their taxable account is equity-heavy after several good years for stocks. They prefer to rebalance using contributions in their 401(k) and IRA (tax-advantaged) to avoid triggering capital gains in the taxable account.

Example 3, Use of ETFs: ETFs like $VOO (S&P 500) and $BND (aggregate bonds) are common building blocks because they are easy to buy in small increments and tend to have low fees. Rebalancing between broad ETFs can be low-cost and straightforward.

Common Mistakes to Avoid

• Rebalancing too often: Excessive trading increases transaction costs and may reduce returns. Avoid rebalancing based solely on short-term volatility.
• Ignoring taxes: Selling winners in taxable accounts without considering capital gains taxes can be costly. Use contributions and tax-advantaged accounts first.
• Letting emotions drive decisions: Rebalancing forces disciplined buying and selling. Avoid changing your target allocation because of short-term market news.
• Not considering costs: Commissions, bid-ask spreads, and fund expense ratios matter, especially for smaller accounts. Choose low-cost funds and consider thresholds or automations to minimize trades.
• Failing to update targets: Life events (change in time horizon, income, or goals) may require adjusting your target allocation. Rebalancing to an outdated allocation can be harmful.

FAQ

Q: How often should I rebalance my portfolio?

A: There is no one-size-fits-all answer. Common choices are annually or quarterly for calendar-based rebalancing. Threshold-based rebalancing (e.g., rebalance when an allocation drifts by 5%) is another option. Many investors use a hybrid approach: check quarterly but only rebalance if drift exceeds the threshold.

Q: Will rebalancing reduce my long-term returns?

A: Rebalancing may slightly change returns because it involves selling winners and buying losers, which can underperform in trending markets. However, it reduces unintended risk and helps maintain the risk profile you chose; for many investors, that risk control is more valuable than marginal differences in return.

Q: Can I rebalance without selling investments?

A: Yes. Use new contributions and dividend reinvestment to buy underweight assets, and let winners grow in other accounts. This approach is tax-efficient in taxable accounts and can minimize transaction costs.

Q: Should I rebalance during a market crash?

A: Rebalancing during a crash may mean buying more of depressed assets, which can be a disciplined move if it fits your risk tolerance and time horizon. However, be mindful of emotions, cash needs, and taxes. If you need cash soon, preserving liquidity might be more important than rebalancing to target.

Bottom Line

Rebalancing is a simple but powerful portfolio maintenance habit that helps you stay aligned with your risk tolerance and investment goals. Whether you choose calendar-based, threshold-based, or hybrid rebalancing, consistency and a clear set of rules are most important.

Actionable next steps: pick a target allocation, choose a rebalancing method that fits your situation, decide where to rebalance (taxable vs tax-advantaged), and set up automation if available. Track costs and tax implications, and update your target allocation when life changes.

Keeping your portfolio on target is not about timing the market; it's about keeping your plan intact so it can work for you over the long run.