Rebalancing 101: When and How to Rebalance Your Portfolio

Introduction

Portfolio rebalancing is the process of returning your investments to a chosen target allocation after market movements change the mix. For a beginner, it is the key maintenance practice that helps preserve your intended risk level and long-term plan.

This article explains why rebalancing matters for investors of every size and experience level. You will learn the main strategies (time-based and threshold-based), a clear step-by-step rebalancing process, and practical tips to do it efficiently and tax-aware.

Preview: we cover the why, compare common approaches, walk through numeric examples, and list common mistakes so you can start rebalancing with confidence.

• Rebalancing keeps your portfolio aligned with your risk and return goals by restoring your target asset mix.
• Common strategies: time-based (e.g., yearly) and threshold-based (e.g., 5% bands), each with trade-offs.
• Practical methods include using new contributions, partial rebalancing, or trading to sell winners and buy laggards.
• Account type matters: use taxable accounts thoughtfully to limit tax events; favors contributions/withdrawals before selling.
• Simple rules reduce emotion: set a plan, check periodically, and avoid over-trading due to short-term noise.

Why Rebalancing Matters

When different parts of your portfolio grow at different rates, the percentage each asset class represents changes. That drift means your portfolio could become riskier or more conservative than you intended without you noticing.

For example, a 60% equity / 40% bond portfolio may shift to 70/30 after a strong stock market run, increasing volatility and potential drawdowns. Rebalancing restores the original risk profile so your portfolio behavior remains consistent with your goals.

Rebalancing also enforces disciplined behavior: it naturally leads you to sell high and buy low. Over long periods this discipline can improve risk-adjusted returns and help avoid emotionally driven trading decisions.

Rebalancing Strategies

Choosing a rebalancing strategy depends on your tolerance for complexity, tax situation, and the amount of time you want to spend managing your portfolio. Two common approaches are time-based and threshold-based.

Time-based rebalancing

Time-based rebalancing means you rebalance on a fixed schedule: monthly, quarterly, semiannually, or annually are typical choices. It’s simple to implement and easy to automate with many brokerages and robo-advisors.

Pros: predictable and low-effort. Cons: you may trade unnecessarily after small moves, which can increase costs or tax consequences in taxable accounts.

Threshold-based rebalancing

Threshold-based rebalancing triggers when an asset class deviates from its target by a specific percentage, for example a 5% or 10% band. If your 60% equity target moves to 66% (a 6 percentage-point drift), you rebalance back to 60%.

Pros: focuses activity where it matters and can reduce trading. Cons: requires more monitoring and you may go long stretches without rebalancing during low volatility.

Combining methods

Many investors use a hybrid approach: check annually but only rebalance when thresholds are breached. This reduces unnecessary trades while ensuring drift doesn’t go unchecked.

Consider your tolerance for monitoring, trading costs, and taxes when picking a plan. Simpler is often better for beginners.

How to Rebalance: Step-by-Step

This clear process works for individual investors managing typical allocations of stocks, bonds, and cash. Follow it each time you rebalance.

1. Check current allocations. Add up the market value of each asset class across all accounts and calculate percentages.
2. Compare to target. Subtract target allocation from current allocation to find the drift (positive means overweight, negative means underweight).
3. Decide rebalancing method. Use time-based, threshold-based, or a hybrid rule you’ve pre-set.
4. Choose execution approach. Use new contributions, withdrawals, or trades to rebalance. Prefer contributions/withdrawals first in taxable accounts to reduce capital gains.
5. Perform trades. Sell assets that are overweight and buy assets that are underweight. Consider partial rebalancing if transaction costs or taxes are a concern.
6. Record the changes. Note the date, trades, and reason for the rebalance so you can review the rule’s performance later.

Execution choices explained

There are three practical ways to rebalance:

• Use new cash flows: direct new contributions to underweight asset classes to avoid selling winners.
• Selling and buying: sell portions of overweight holdings and buy underweight ones. This is the most direct but may trigger taxes.
• Trade within tax-advantaged accounts: prefer rebalancing in IRAs, 401(k)s, or other tax-deferred accounts where trades are tax-free.

Partial rebalancing

Partial rebalancing means adjusting only a fraction (for example, half) of the drift. This reduces trading costs and taxes while nudging you back toward target.

Partial rebalancing is useful when thresholds are small or when you want to smooth trading over time.

Real-World Examples

Concrete numbers make rebalancing easy to understand. Below are two realistic scenarios showing how rebalancing works in practice.

Example 1: 60/40 portfolio after a strong stock year

Start: $100,000 portfolio with 60% stocks ($60,000) and 40% bonds ($40,000). After a year of strong stock returns, stocks rise 25% and bonds rise 2%.

New values: stocks = $60,000 * 1.25 = $75,000; bonds = $40,000 * 1.02 = $40,800; total = $115,800. Stocks now equal 64.7% ($75,000 / $115,800) and bonds 35.3%.

To rebalance back to 60/40 you need stocks = $69,480 (60% of total) and bonds = $46,320 (40%). That means selling $5,520 of stocks and buying $5,520 of bonds.

Execution tip: if you have planned contributions, you could direct the next $5,520 to bonds instead of selling stocks, avoiding a taxable trade in a taxable account.

Example 2: Threshold trigger with ETFs

Suppose you target 50% domestic equities ($VTI), 30% international equities ($VXUS), and 20% bonds ($BND) across an investment account. You use a 5% threshold rule.

If $VTI grows so the allocation becomes 56% (a +6 point drift), it breaches the 5% threshold. You rebalance by selling a portion of $VTI and buying $VXUS and $BND to restore 50/30/20.

Using ETFs like $VTI, $VXUS, and $BND simplifies trading and keeps transaction costs low for many investors.

Tax and Cost Considerations

Taxes and fees can erode the benefits of rebalancing if not managed. Recognize which accounts are taxable and which are tax-advantaged before executing trades.

Best practices:

• Prioritize rebalancing inside tax-deferred accounts (IRAs, 401(k)s) where trades don’t create immediate capital gains.
• In taxable accounts, use new contributions or withdrawals first to avoid selling winners and creating taxable events.
• Be mindful of short-term capital gains: holding an asset longer than 12 months before selling yields preferable long-term rates for many investors.

Common Mistakes to Avoid

• Rebalancing too often: Excessive trading can increase costs and taxes. Use reasonable schedules or thresholds to limit activity.
• Ignoring taxes: Selling winners in taxable accounts without considering capital gains can reduce net returns. Use contributions and tax-advantaged accounts where possible.
• Letting target drift for too long: Large drifts change your risk profile. Set checks (annual reviews or thresholds) to catch big deviations.
• Selling losers only to avoid losses: Rebalancing requires buying underperformers at times. Avoid emotional decisions to hold losers or chase recent winners.
• Overcomplicating your approach: Complex rules may be hard to follow. A simple, consistent plan you can stick with is usually better for beginners.

FAQ

Q: How often should I rebalance my portfolio?

A: There’s no one-size-fits-all answer. Common choices are annually or semiannually for time-based plans. Alternatively, use threshold-based rules (e.g., rebalance when an allocation deviates by 5%). Combining both, checking once a year and rebalancing only if thresholds are exceeded, is a practical approach for many beginners.

Q: Will rebalancing lower my returns?

A: Rebalancing can reduce extreme gains from high-performing assets but helps control risk and volatility. Over time, disciplined rebalancing can improve risk-adjusted returns even if it slightly reduces peak returns from concentrated winners.

Q: Should I rebalance in taxable accounts?

A: You can, but be tax-aware. Prefer using new contributions, withdrawals, or rebalancing inside tax-advantaged accounts first to limit taxable trades. When you must sell in taxable accounts, consider holding periods to reduce short-term capital gains.

Q: What if I have many small accounts or lots of individual stocks?

A: Consolidate reporting where possible to see the full allocation across accounts. For many small positions, consider using ETFs to capture whole asset classes or do partial rebalancing to manage costs. Prioritize rebalancing major asset classes that drive risk.

Bottom Line

Rebalancing is a simple, disciplined way to keep your portfolio aligned with your goals and risk tolerance. Whether you choose a time-based, threshold-based, or hybrid approach, the most important element is a consistent, documented plan you can follow.

Start by defining a realistic target allocation, pick a rebalancing rule you can maintain, and favor tax-aware execution methods. Small, regular maintenance will keep surprises low and make long-term investing calmer and more predictable.

Next steps: determine your target allocation, choose a rebalancing rule (e.g., annual check with a 5% threshold), and set calendar reminders or automation within your brokerage to enforce the plan.