Why rebalancing matters

Rebalancing is a disciplined way to enforce the risk profile you designed when you chose an asset allocation. Without it, a portfolio tilted by market moves can carry much more (or much less) risk than you intended. For example, a 60/40 stocks/bonds plan can drift to 75/25 after a strong equity run, increasing volatility and potential drawdown during the next market drop.

Rebalancing forces two beneficial behaviors: you sell relatively expensive assets and buy relatively cheap ones, and you maintain exposure consistent with your financial plan. The U.S. Securities and Exchange Commission and financial educators recommend rebalancing as part of prudent portfolio management (see SEC: Rebalancing Your Portfolio).

In my practice working with clients over 15 years, I’ve seen portfolios drift by double-digit percentage points in 12–24 months during volatility. A repeatable rebalancing rule prevents emotional, ad-hoc trades that often hurt long-term returns.

When should you rebalance? (calendar vs. threshold vs. event-driven)

There are three common timing approaches—each has trade-offs:

  • Scheduled (calendar) rebalancing: check and rebalance monthly, quarterly, semiannually, or annually. Simpler to implement; lowers behavioral friction. Many advisors default to quarterly or annually for small retail portfolios.

  • Threshold (band) rebalancing: rebalance only when an asset class drifts past a set tolerance, e.g., 5% or 10% from target. This reduces trading and can be more tax-efficient but requires monitoring.

  • Event-driven rebalancing: rebalance after large market moves or life events (e.g., inheritance, job change, retirement) that meaningfully alter goals or cash flows.

Which to choose? Use calendar rules for simplicity and discipline; use threshold rules to avoid small, costly trades; combine them by reviewing on a schedule and acting only when bands are breached. In my client work, a hybrid approach—quarterly reviews with a 5%–10% band—balances costs and risk control.

How to rebalance: step-by-step

  1. Confirm your target allocation and why it’s appropriate (time horizon, risk tolerance, liquidity needs). Document it.
  2. Measure current allocations across all accounts (taxable, IRAs, 401(k)s). Include cash positions. Use a spreadsheet or portfolio tool.
  3. Compare current vs target and identify overweights and underweights.
  4. Choose a rebalancing method:
  • Buy/sell to move positions back to target.
  • Use new contributions and dividends to buy underweighted assets (tax-efficient).
  • Exchange within tax-advantaged accounts first (no immediate tax consequences).
  • Use partial rebalancing if you want to limit turnover.
  1. Execute trades, paying attention to transaction costs, bid–ask spreads, and tax lot implications.
  2. Record trades and update documentation for future reviews.

Methods and practical considerations

  • Use tax-advantaged accounts first: Rebalancing inside IRAs, 401(k)s, and other tax-deferred accounts avoids immediate capital gains. This is often the most tax-efficient path.

  • Taxable accounts require care: Selling appreciated securities can trigger capital gains taxes. Consider tax-loss harvesting opportunities, selling loss lots to offset gains, or matching sells to long-term vs. short-term lots to manage rates. Broker tools often help select tax-efficient lots—see our deeper guide on Using tax-efficient lots when rebalancing taxable accounts.

  • Use new cash flows: Direct new contributions to underweight areas before selling winners. This reduces realized gains and lowers turnover.

  • ETFs and mutual funds: ETFs offer intraday trading flexibility and often low costs; mutual funds can be cheaper for periodic small purchases because many brokerages offer commission-free trades and automatic investment plans. Learn more about using ETFs to implement tactical allocation.

  • Partial rebalancing: Instead of restoring exactly to target, shift partially—e.g., move halfway back to target—to reduce taxes and trading costs while nudging the portfolio in the right direction.

Example calculations

Target: 60% equities / 40% bonds; Portfolio value: $200,000. Current: equities $150,000 (75%), bonds $50,000 (25%).

  • Target equity dollar amount = 60% × $200,000 = $120,000.
  • Sell equities = $150,000 − $120,000 = $30,000.
  • Use proceeds to buy bonds to reach $80,000 target.

If you prefer partial rebalancing at 50% of the gap: sell $15,000 of equities and buy $15,000 of bonds.

Costs, taxes, and behavioral traps

  • Trading costs and bid–ask spreads matter for small accounts. Many brokerages now offer commission-free trades, but taxes remain.

  • Capital gains: Realizing gains in taxable accounts increases your current tax bill. Prioritize rebalancing inside tax-advantaged accounts when possible. For unavoidable sales, aim to realize long-term rather than short-term gains.

  • Overtrading: Rebalancing too frequently can erode returns with fees and taxes. A threshold of 5% is common; some advisors use 10% for broader asset classes.

  • Market timing temptation: Rebalancing enforces a buy-low/sell-high discipline—avoid trying to time markets between reviews.

Asset location and rebalancing across account types

Asset location (placing tax-inefficient assets like taxable bonds in tax-advantaged accounts and equities in taxable accounts) affects rebalancing flexibility. When you rebalance, consider the whole household portfolio across accounts, not just a single account. Our article on Asset Allocation Fundamentals explains how allocation decisions interplay with account type.

Tools and automation

  • Many brokerages and robo-advisors offer automated rebalancing. Robo-advisors typically rebalance based on thresholds and include tax-loss harvesting where appropriate. Automation reduces behavioral mistakes and administrative burden.

  • Portfolio software can track drift and suggest trades across accounts. Use these tools to see the full picture and avoid unintended concentration.

Common mistakes and how to avoid them

  • Waiting too long because of fear of taxes: balance current tax cost against long-term risk of an unbalanced portfolio.

  • Rebalancing without updating goals: If life priorities or risk tolerance changed, revise the target allocation first.

  • Ignoring correlations: Rebalancing purely by asset class weights may miss concentration in correlated exposures (e.g., all domestic large-cap growth). Review underlying exposures periodically.

Quick rebalancing checklist

  • Confirm target allocation and reasons for it.
  • Aggregate holdings across all accounts.
  • Choose method (calendar, threshold, hybrid).
  • Rebalance tax-advantaged accounts first.
  • Use new contributions to buy underweights.
  • Consider partial rebalancing where taxes are material.
  • Document trades and the decision for compliance and future reviews.

Real-world scenarios: two brief client examples

1) Growth run: A client’s equity exposure rose from 60% to 75% after a multi-year bull market. We rebalanced by selling $30k of appreciated equities inside their IRA and directing new savings into bond funds. The move reduced next-cycle volatility and better matched their time horizon.

2) Downturn opportunity: After a market drop moved their allocation to 40% equities/60% bonds, we used the client’s monthly contributions and a modest sell of bonds in a taxable account (using harvested losses elsewhere) to restore a 60/40 mix—effectively buying equities at lower prices.

Sources and further reading

  • U.S. Securities and Exchange Commission, “Rebalancing Your Portfolio” — https://www.sec.gov/investor/alerts/ib_rebalancing.pdf and investor guides on the SEC site.
  • Vanguard, “Rebalancing your portfolio” — investor education on strategies and trade-offs.
  • FINRA investor education on portfolio rebalancing and tax-aware strategies.

Final notes and disclaimer

Rebalancing is a core practice that helps maintain risk control and align investments with long-term objectives. The right frequency and method depend on account types, tax considerations, costs, and your personal situation.

This article is educational and not personalized investment advice. For tailored recommendations, consult a licensed financial planner or tax professional familiar with your full financial picture.