What is Portfolio Rebalancing?
Portfolio rebalancing is the process of realigning your investment portfolio back to your target asset allocation. Over time, as different investments grow at different rates, your portfolio naturally drifts from its intended mix—this is called portfolio drift.
For example, if you start with a 60/40 stock/bond allocation, a strong stock market could push your actual allocation to 70/30, exposing you to more risk than intended.
Portfolio Rebalancing in Action
Before: Drifted Portfolio
After: Target Allocation
Rebalancing involves selling some of your winners and buying more of the underperformers to get back to your target. While this may feel counterintuitive, it's a disciplined way to "sell high, buy low" and manage portfolio risk.
Why Rebalancing Matters
1. Risk Control
Without rebalancing, your portfolio naturally becomes riskier over time as stocks outperform bonds. A portfolio that drifts from 60/40 to 80/20 has significantly more volatility and downside risk than intended.
2. Disciplined Investing
Rebalancing forces you to sell assets that have risen and buy those that have fallen—the opposite of emotional investing. This systematic approach removes emotion from investment decisions.
3. Return Enhancement
Research shows that disciplined rebalancing can add 0.5% to 1.0% annually to portfolio returns through the "rebalancing bonus"—capturing gains from volatility across asset classes.
Key Insight
Rebalancing is primarily about risk management, not return maximization. A portfolio that never rebalances might have higher returns in a long bull market, but will also have much higher risk and potentially devastating drawdowns.
Rebalancing Methods
There are several approaches to rebalancing, each with its own advantages and trade-offs.
Calendar Rebalancing
Rebalance at fixed intervals (monthly, quarterly, annually) regardless of how much drift has occurred.
Threshold Rebalancing
Rebalance only when allocations drift beyond a set threshold (e.g., 5% absolute or 25% relative).
Cash Flow Rebalancing
Direct new contributions (or withdrawals) to underweight (or overweight) assets to naturally rebalance.
Hybrid Approach
Combine methods: use cash flows for minor adjustments, sell/buy for major rebalancing when thresholds are breached.
Setting Rebalancing Thresholds
The most popular threshold approach is the 5/25 rule, which triggers rebalancing when either condition is met:
- 5% Absolute: Rebalance when any asset class drifts 5 percentage points from target
- 25% Relative: Rebalance when any asset class drifts 25% of its target allocation
5/25 Rule Examples
| Target | Current | Absolute Drift | Relative Drift | Rebalance? |
|---|---|---|---|---|
| 60% Stocks | 67% | +7% | +11.7% | Yes (>5%) |
| 20% Bonds | 18% | -2% | -10% | No |
| 10% Int'l | 7% | -3% | -30% | Yes (>25%) |
| 10% REITs | 8% | -2% | -20% | No |
Why Use Both Thresholds?
The absolute threshold (5%) catches major drifts in large allocations, while the relative threshold (25%) catches significant drifts in smaller positions that might otherwise be ignored.
Tax-Efficient Rebalancing Strategies
Rebalancing in taxable accounts can trigger capital gains taxes. Here are strategies to minimize the tax impact:
💡 Tax-Smart Rebalancing Tips
- Rebalance in tax-advantaged accounts first — 401(k), IRA, and Roth accounts have no tax consequences for trades
- Use new contributions — Direct deposits to underweight assets instead of selling
- Harvest losses — If selling in taxable accounts, prioritize positions with losses
- Use dividends and interest — Reinvest distributions into underweight assets
- Consider asset location — Keep tax-inefficient assets in tax-advantaged accounts to allow tax-free rebalancing
- Wait for long-term gains — If possible, hold winning positions for >1 year before selling
Account Priority for Rebalancing
- 401(k), 403(b), Traditional IRA: Rebalance freely—no tax impact until withdrawal
- Roth IRA: Rebalance freely—withdrawals are tax-free
- HSA: Rebalance freely—triple tax advantage
- Taxable brokerage: Last resort—consider tax-loss harvesting opportunities
Step-by-Step Rebalancing Guide
Your Rebalancing Checklist
Rebalancing Frequency Recommendations
- Passive investors: Annually, or when thresholds are breached
- Active investors: Quarterly review with threshold-based execution
- Volatile markets: Monthly monitoring, but still use thresholds to avoid overtrading
- Tax-conscious investors: Year-end rebalancing to optimize tax-loss harvesting
Frequently Asked Questions
Most experts recommend rebalancing annually or when allocations drift more than 5% from targets. More frequent rebalancing (monthly or quarterly) increases transaction costs and potential tax consequences without significantly improving returns. The key is consistency—pick a method and stick with it.
The 5/25 rule triggers rebalancing when an asset class drifts 5 percentage points from its target (absolute) or 25% of its target allocation (relative). For a 20% target allocation, this means rebalancing when it reaches 15% or 25%. The rule prevents both overtrading on minor fluctuations and excessive risk from large drifts.
Always prioritize rebalancing in tax-advantaged accounts (401k, IRA, Roth) first to avoid triggering capital gains taxes. In taxable accounts, try to rebalance using new contributions, dividend reinvestment, and tax-loss harvesting rather than selling appreciated assets.
In certain market conditions, yes. If stocks continuously outperform bonds, constantly selling stocks to buy bonds will reduce returns compared to a buy-and-hold approach. However, rebalancing's primary purpose is risk management, not return maximization. Without rebalancing, your portfolio could become dangerously overweight in volatile assets just before a market crash.
Yes, if your thresholds are breached. Rebalancing during a crash means buying stocks at lower prices—exactly what "buy low, sell high" implies. However, this requires emotional discipline. Stick to your predetermined thresholds rather than making emotional decisions based on market conditions.