Introduction
Portfolio rebalancing is the process of returning your investments to a target asset allocation after market movements have caused drift. It matters because drift changes your risk exposure, and uncontrolled drift can leave you taking more or less risk than you planned.
In this article you'll learn the main rebalancing strategies, the trade-offs between time-based and threshold-based approaches, and practical steps you can use to rebalance with minimal tax and cost impact. Along the way you'll see real examples using broad ETFs and individual stocks so you can apply these ideas to your accounts.
- Rebalancing keeps your portfolio risk consistent with your plan and enforces a buy low, sell high discipline.
- Time-based schedules are simple and predictable, threshold-based rules are opportunistic and can reduce unnecessary trades.
- Use tax-advantaged accounts and new contributions to rebalance when possible to avoid capital gains.
- Common techniques include full rebalance, partial rebalance, and using cash flows or dividends to restore targets.
- Watch for taxes, transaction costs, and behavioral traps when deciding how often to rebalance.
Why Rebalancing Matters
When different parts of your portfolio grow at different rates your allocation drifts away from the target. That drift changes both expected return and volatility, so rebalancing restores the risk profile you chose when you built the plan.
Rebalancing also enforces a systematic discipline of trimming winners and adding to laggards. When equities have outperformed bonds you sell some equities and buy bonds, which is essentially selling high and buying low over time.
Finally, rebalancing can improve risk-adjusted returns. You should not expect it to always boost absolute returns, but by controlling volatility and avoiding concentration it often improves outcomes for long-term investors.
Time-Based vs Threshold-Based Strategies
There are two common families of rebalancing rules. Time-based approaches rebalance on a fixed schedule, like quarterly or annually. Threshold-based approaches rebalance only when allocations move beyond a set band, like 5 or 10 percentage points from target.
Time-Based Rebalancing
Time-based rules are easy to implement and automate. For example, you might check your allocation on the first trading day of January and rebalance back to target once per year. That simplicity helps you avoid decision paralysis and the temptation to time the market.
Quarterly rebalancing reduces drift more often but increases trading and potential taxes in taxable accounts. Annual rebalancing often hits a balance between control and cost. Many advisors recommend annual or semi-annual checks for typical retail portfolios.
Threshold-Based Rebalancing
Threshold-based rules only trigger when an asset class moves enough to matter. A common threshold is 5 percentage points. If your target is 60% equities and equities rise to 66%, you would rebalance because the drift exceeded 5 points.
This method reduces needless trading in sideways markets and can be more efficient, but it requires monitoring and sometimes multiple checks per year. It can also lead to irregular workloads when markets move quickly.
Which Should You Use?
Choose based on your tolerance for trading, tax situation, and how busy you want to be. If you prefer predictability, pick a time-based schedule. If you want to minimize trades and are willing to monitor your portfolio, choose thresholds. You can also combine approaches, for example, checking annually and also rebalancing if any holding drifts by more than 7 points during the year.
How to Rebalance: Practical Methods
Execution matters as much as the rule you pick. The easiest methods are full rebalancing, partial rebalancing, and using cash flows. Each has different tax and cost implications.
Full Rebalance
A full rebalance sells and buys across all holdings until each asset class matches the target percentages exactly. This is clean and precise, but it can generate significant trading and capital gains in taxable accounts.
Partial Rebalance
Partial rebalancing means bringing allocations partway back toward target, for example rebalancing half the difference. This reduces turnover and spreads tax impact across years. It also smooths execution when market moves are large.
Use Cash Flows
One low-cost way to rebalance is to direct new contributions, dividends, or interest to underweight asset classes. If you have a 60/40 portfolio and equities drift to 65%, route new cash to bonds until you reach the target again. This avoids selling winners and helps limit taxes.
Tax-Aware Rebalancing
In taxable accounts you should prefer methods that minimize realized gains. Use tax-advantaged accounts like IRAs and 401(k)s for trims that would otherwise create gains. Consider selling holdings with losses first to offset gains, and harvest tax losses when appropriate.
Real-World Examples
Concrete scenarios make this actionable. Below are two realistic cases using simple numbers and common ETFs and stocks.
Example 1: 60/40 Portfolio, Annual vs Threshold
Start: $100,000 portfolio, 60% equities ($VTI) = $60,000, 40% bonds ($BND) = $40,000. After a strong equity year, equities rise 35% and bonds rise 3%.
- Equities new value: $60,000 times 1.35 = $81,000.
- Bonds new value: $40,000 times 1.03 = $41,200.
- Total portfolio = $122,200, equity allocation = 66.3% and bonds = 33.7%.
If you rebalance annually you would sell about $6,160 of equities and buy bonds to return to 60/40. If you use a 5-point threshold you would not rebalance because drift is 6.3 points and would trigger action. If your threshold were 7 points you would wait.
Tax note: Selling $6,160 of $VTI in a taxable account may realize capital gains. To avoid this, you could use new contributions to buy $BND until you restore 60/40, or perform the rebalancing inside a 401(k) if available.
Example 2: Concentration in a Winner Stock
Suppose you own $20,000 in $NVDA inside a $200,000 portfolio, so NVDA is 10%. After a rally NVDA doubles to $40,000 and now represents 20% of the portfolio. That creates concentration risk.
A threshold rule might trigger a rebalance at 15% concentration, so you sell enough NVDA to reduce exposure back to the target, perhaps trimming to 12% rather than exactly to 10% to spread gains across time. If NVDA is in a taxable account selling will create capital gains, so consider selling in tax-advantaged accounts first and then using cash flows to reduce concentration in taxable accounts.
Costs, Taxes, and Behavioral Factors
Rebalancing is not free. Trading costs and taxes eat into returns. In low-cost brokerages transaction fees are often negligible for ETFs, but bid-ask spread and market impact still matter for large trades or thinly traded securities.
Taxes are the biggest practical constraint for many investors. Realized capital gains in taxable accounts can convert paper gains into tax liability. Use tax-advantaged accounts for more aggressive rebalancing, and prioritize using inflows and dividends to rebalance in taxable accounts.
Behaviorally, rebalancing helps counteract common investor biases such as chasing recent winners. It forces a disciplined process so you don't drift into unwanted risk. Ask yourself, are you rebalancing to follow your plan, or reacting to a recent story?
Common Mistakes to Avoid
- Rebalancing too frequently, which increases trading costs and could trigger unnecessary taxes. How to avoid: pick a reasonable schedule, like annual checks, or use a wider threshold.
- Ignoring tax consequences by selling winners in taxable accounts. How to avoid: use tax-advantaged accounts, route new cash to underweights, and harvest losses when practical.
- Letting emotions drive rebalancing decisions after dramatic market moves. How to avoid: commit to a rule in advance and document your target allocation and rebalance triggers.
- Overreacting to short-term volatility and abandoning your long-term allocation. How to avoid: review your time horizon and risk tolerance before making allocation changes.
- Failing to update your target allocation as life circumstances change. How to avoid: review your allocation annually alongside major life events like retirement or inheritance.
FAQ
Q: How often should I rebalance a simple stock/bond portfolio?
A: Annual rebalancing is a common and reasonable default for many investors, with quarterly or semi-annual checks if you prefer tighter control. You can also add a threshold trigger, for example rebalance sooner if allocation drifts by more than 5 percentage points.
Q: Should I rebalance taxable accounts the same way I rebalance retirement accounts?
A: Not necessarily. Use tax-advantaged accounts to do the most trading, and prefer cash flows and dividends to rebalance taxable accounts. When you must sell in taxable accounts, consider tax-loss harvesting and realize gains gradually to manage tax impact.
Q: What threshold is appropriate for triggering a rebalance?
A: Many investors use 3 to 7 percentage points for core asset classes. Smaller thresholds mean more frequent trades, larger thresholds allow more drift but reduce turnover. Choose a band that matches your willingness to trade and your tax sensitivity.
Q: Can rebalancing hurt returns by selling winners that continue to rise?
A: Yes, in any single period rebalancing can reduce short-term gains if winners keep running. Over many periods rebalancing tends to improve risk-adjusted returns by preventing concentration. The decision should be based on your long-term plan, not short-term momentum.
Bottom Line
Rebalancing is a core part of portfolio maintenance that keeps your risk aligned with your plan and enforces a disciplined buy low, sell high approach. You can use time-based schedules, threshold triggers, or a hybrid of both depending on your preferences for simplicity and trading frequency.
To act, pick a target allocation, choose a rebalancing rule you can stick with, and use tax-aware execution techniques like directing new contributions and using tax-advantaged accounts for trades. At the end of the day, consistent, thoughtful rebalancing will help you maintain the exposure you intended and avoid surprise risks as markets move.
