Rebalancing is a crucial investment practice that involves restoring your portfolio to your intended asset allocation after market fluctuations cause it to drift. Imagine your portfolio as a pie chart with slices representing stocks, bonds, and other asset classes. Over time, some slices may grow larger or smaller due to varying market returns, leading your portfolio away from its original balance. By rebalancing, you sell portions of overperforming assets and buy more of underperforming ones to maintain your risk tolerance and investment strategy.
Why is rebalancing important?
Market volatility can significantly shift your portfolio’s allocation. For example, if stocks outperform bonds, their increased weight may expose you to more risk than you planned. Conversely, if stocks underperform, your portfolio might become too conservative, limiting growth potential. Rebalancing corrects these drifts, helping you “buy low” and “sell high,” which can improve your investment outcomes over time.
How to rebalance your portfolio
There are two primary approaches:
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Selling and Buying: You sell assets that exceed your target allocation and use the proceeds to purchase assets that are underweight. For example, with a target of 60% stocks and 40% bonds, if stocks grow to 70%, you sell $10,000 of stocks and buy $10,000 of bonds to return to the target.
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Using New Contributions: Instead of selling, direct new investment contributions toward underweighted assets until your allocations realign. This method is tax efficient, especially within tax-advantaged accounts like IRAs or 401(k)s.
When to rebalance?
- Calendar-based: Rebalance on a fixed schedule such as annually or semi-annually.
- Threshold-based: Rebalance when an asset class deviates by a set percentage (e.g., 5%) from its target.
- Hybrid: Combine both methods for flexibility.
Who should rebalance?
Any investor with a diversified portfolio should consider rebalancing. This includes individual investors managing IRAs or 401(k)s, financial advisors maintaining client portfolios, and institutional investors.
Best practices and common mistakes
- Automate rebalancing when possible using robo-advisors or brokerage services.
- Be mindful of tax consequences in taxable accounts.
- Avoid rebalancing too frequently to minimize transaction costs.
- Periodically revisit your target allocation to reflect changes in your goals or risk tolerance.
Real-world examples
A stock rally increases the stock portion from 70% to nearly 74%; an investor sells some stocks and buys bonds to return to the 70/30 split. Conversely, during a downturn, directing new contributions towards stocks can gradually restore allocation without selling assets.
For more detailed strategies on asset allocation and how to manage risk, see our glossary entries on Asset Allocation and Portfolio Rebalancing.
Additional Resource
Visit the IRS website for information on tax considerations related to investment trading in taxable accounts: IRS – Investment Income and Expenses.
Rebalancing is not about market timing but disciplined portfolio management to help you stay on course toward your financial goals over the long term.