Introduction
Rebalancing a portfolio means returning your investments to the target mix you chose to match your goals and risk tolerance. Over time some assets will grow faster than others, and without action your portfolio can drift away from that target.
Why should you care about rebalancing? If you don’t, you may end up taking more risk than you intended or missing opportunities to buy assets that are cheaper now. This guide will explain what rebalancing is, when to do it, and exactly how to rebalance using simple, practical methods you can use right away.
You'll learn calendar-based and threshold-based approaches, tax-aware tips, and concrete examples using $VTI and $BND. Ready to keep your portfolio aligned with your plan?
Key Takeaways
- Rebalancing returns your portfolio to a target allocation so your risk stays consistent with your plan.
- Common rules are annual rebalancing or rebalancing when an asset class drifts by a set percentage, for example 5% or 10%.
- Rebalance by selling some of the winners and buying the lagging assets, or use new contributions to buy what's underweight.
- Be tax-aware: prefer rebalancing in tax-advantaged accounts, use new money, or harvest tax losses in taxable accounts.
- Keep costs and trading friction low by using ETFs, periodic schedules, and minimum thresholds to avoid overtrading.
Understanding Rebalancing
At its core, rebalancing is a maintenance task. You set a target allocation, such as 60% stocks and 40% bonds, and you periodically adjust holdings so they match that split again. That keeps your portfolio behaving the way you expect as markets move.
Why allocations drift? Different asset classes have different returns and volatility. Stocks often rise faster than bonds over the long run, so a 60/40 portfolio can become stock-heavy after a rally. Rebalancing forces a disciplined buy-low, sell-high process by trimming winners and adding to losers.
Key terms defined
- Target allocation, the planned percentage split between asset classes such as stocks and bonds.
- Drift, the amount an allocation moves away from its target.
- Threshold, the drift percentage that triggers a rebalance, for example 5% or 10%.
When to Rebalance
There are two common approaches beginners use: calendar-based and threshold-based. Both work well and you can combine them to suit your preferences. The goal is to rebalance often enough to control risk but not so often that fees or taxes eat returns.
Calendar-based rebalancing
Calendar-based means you rebalance on a regular schedule, such as once a year or quarterly. Annual rebalancing is popular because it’s simple and reduces trading frequency. A common practice is to pick a fixed date, review your allocation, and rebalance if needed.
Threshold-based rebalancing
Threshold-based rebalancing waits until an asset class moves a set amount away from the target, usually 5% or 10%. For example, with a 60/40 target you might rebalance when stocks exceed 65% or fall below 55%. This method adapts to market volatility and can reduce unnecessary trades.
Which method should you use?
If you prefer simplicity, annual rebalancing is easy to stick with. If you want more control and you monitor your accounts, a 5% threshold gives you a practical balance between discipline and trading costs. You can also combine them by checking annually and rebalancing sooner if a threshold is crossed.
How to Rebalance: Step-by-Step
Rebalancing is a straightforward process. Below are step-by-step methods you can follow depending on whether you want to trade or use new contributions to rebalance.
1. Confirm your target allocation
Write down your target percentages. Example: 60% U.S. stocks, 20% international stocks, 20% bonds. Keep your target realistic for your time horizon and risk tolerance.
2. Measure current allocation
Check the current market value of each holding and calculate the percentage of the total portfolio. Many brokerages show this automatically, but you can add up market values and divide by the total to get each percentage.
3. Decide whether to rebalance
Compare current percentages to targets. If any asset class has drifted beyond your threshold or it's your scheduled review date, plan trades. Otherwise wait until the next check.
4. Rebalance with the least friction
- Use new contributions: Direct new money to underweight asset classes until targets are restored. This avoids selling and may save taxes.
- Sell winners and buy losers: Sell just enough of the overweight asset to buy the underweight asset and reach targets.
- Hybrid approach: Use contributions and small trades to minimize taxes and trading costs.
When selling, account for trading fees, bid/ask spreads, and potential capital gains taxes in taxable accounts. Prefer tax-advantaged accounts like IRAs or 401(k)s for transactions when possible.
5. Record and monitor
After rebalancing, log what you did and why. That makes it easier to follow a consistent plan over time and learn from decisions you make.
Real-World Examples
Concrete examples help make rebalancing tangible. Below are two realistic scenarios with numbers so you can see how the math works.
Example 1: 60/40 portfolio after a stock rally
Start: $100,000 total, $60,000 in stocks ($VTI) and $40,000 in bonds ($BND). Stocks rise 25% over a year while bonds are flat.
- Stocks become $60,000 times 1.25 = $75,000.
- Bonds remain $40,000.
- Total portfolio is now $115,000.
- New stock allocation is $75,000 / $115,000 = 65.2%. Bonds are 34.8%.
If your threshold is 5%, you would rebalance because stocks are 5.2% above the 60% target. To restore 60/40, you need stocks = 60% of $115,000 = $69,000. So you would sell about $6,000 of stocks and buy $6,000 of bonds.
Example 2: Single-stock concentration risk
Imagine you have $10,000 in a diversified ETF and $5,000 in a single stock that doubled after a product success. Your total is now $10,000 plus $10,000 equals $20,000. The single stock is now 50% of your portfolio instead of the intended 25%.
Concentration like this increases risk because company-specific events can sharply move your portfolio. Rebalancing would trim the single stock back toward 25% and buy broader market exposure instead. You might do this immediately if you want to reduce company risk, or you could use a threshold to decide when to act.
Tax and Cost Considerations
Taxes and trading costs affect how you rebalance. In taxable accounts selling winners can create capital gains tax. You can minimize tax impact by rebalancing within IRAs or 401(k)s and using new contributions to direct buys toward underweight assets.
Other tactics include tax-loss harvesting to offset gains and waiting for long-term capital gains treatment where appropriate. Also watch trading fees and bid-ask spreads. Using low-cost ETFs like $VTI and $BND limits transaction costs and makes rebalancing cheaper.
Tools and Automation
Many brokerages and robo-advisors offer automatic rebalancing. Automated tools can rebalance when thresholds are crossed, or on a calendar schedule. For beginners, automation reduces the chance you’ll ignore rebalancing indefinitely.
If you prefer manual control, set calendar reminders, use spreadsheet trackers, or rely on the allocation breakdown tools in your brokerage account to guide decisions.
Common Mistakes to Avoid
- Rebalancing too often: Small, frequent trades increase costs and complexity. Use thresholds and a calendar to limit trading.
- Ignoring taxes: Selling winners in taxable accounts can trigger capital gains. Favor tax-advantaged accounts or use new contributions when possible.
- Reacting to short-term noise: Don’t rebalance because of daily market swings. Stick to your rules and avoid emotional trading.
- Letting a single holding dominate: Concentration risk from a single stock can overwhelm your plan. Use rebalancing to maintain diversification.
- Forgetting to update targets: Life changes like retirement, new income, or changing goals should prompt a review of your target allocation.
FAQ
Q: How often should I rebalance if I’m a beginner?
A: Annual rebalancing is a simple, effective choice for beginners. If you want tighter control, consider a 5% threshold and check quarterly. The most important thing is consistency so you don’t avoid rebalancing entirely.
Q: Should I rebalance in my taxable account if it creates a capital gain?
A: You can rebalance in tax-advantaged accounts first, then use new contributions or small trades in taxable accounts. If a trade would create a large tax bill, consider a gradual approach or tax-loss harvesting to offset gains.
Q: What if one holding, like $AAPL, grows to be a large share of my portfolio?
A: That’s concentration risk. You should consider trimming the position toward your target allocation to reduce company-specific risk. Use a plan that defines a maximum single-holding percentage and rebalance if exceeded.
Q: Will rebalancing lower my returns?
A: Rebalancing can sometimes reduce returns during sustained trends because you sell winners and buy laggards. It also lowers volatility and keeps your risk profile stable. Over the long term it often improves risk-adjusted returns, which helps meet long-term goals.
Bottom Line
Rebalancing is a simple, powerful way to keep your portfolio aligned with your goals and risk tolerance. Whether you rebalance annually or when allocations drift by a set percentage, the key is to choose a clear, repeatable process and stick with it.
Start by writing down your target allocation, pick a rebalancing rule, and decide how you will handle taxes and trading costs. You don’t need to be perfect, but a consistent rebalancing habit will help you avoid unintended risks and stay on track toward your financial goals.
