FinanceFirst financial glossary
What is Rebalancing?
A direct definition, followed by examples, comparisons, related concepts, and the sources that support the explanation.
Written by Asim Ahmad, Founder and Editor, FinanceFirst
Definition
In one sentence about Rebalancing
Rebalancing is the process of realigning the weightings of the assets in your portfolio back to your original target allocation. Over time, market movements cause some investments to grow faster than others, shifting your portfolio away from its intended risk level. Rebalancing restores your desired balance by selling overperforming assets and buying underperforming ones.
Why Rebalancing Matters
Without rebalancing, your portfolio gradually becomes riskier than intended as stocks outperform bonds over time. A portfolio that started as 60% stocks and 40% bonds in 2010 would have drifted to approximately 80% stocks and 20% bonds by 2024 due to the strong stock market performance. This unintended shift means your portfolio would drop significantly more during a downturn than you originally planned for. Rebalancing enforces a disciplined buy-low, sell-high approach because you are systematically selling the assets that have appreciated the most and buying those that have lagged. Vanguard research has shown that regular rebalancing reduces portfolio risk without significantly reducing long-term returns.
Real-World Example: Rebalanced vs. Unrebalanced Portfolio
Here is how a $100,000 portfolio starting with a 70/30 stock/bond allocation performed from 2010-2024, comparing annual rebalancing versus never rebalancing:
| Metric | Rebalanced Annually | Never Rebalanced | Difference |
|---|---|---|---|
| Ending stock allocation | 70% (maintained) | ~83% | 13% higher risk |
| Average annual return | 9.1% | 9.6% | 0.5% lower |
| Maximum drawdown | -18% | -24% | 6% less volatility |
| Portfolio value (2024) | $345,000 | $365,000 | $20,000 |
| Risk-adjusted return (Sharpe) | 0.82 | 0.71 | Better risk-adjusted |
How to Calculate Rebalancing Trades
To rebalance, calculate the difference between your current and target allocation for each asset class, then buy or sell to close the gap. Current allocation = (Asset value / Total portfolio value) x 100. Trade amount = (Target % - Current %) x Total portfolio value. Here is an example for a $200,000 portfolio with a 60/30/10 target allocation:
| Asset Class | Target % | Current Value | Current % | Target Value | Action Needed |
|---|---|---|---|---|---|
| U.S. Stocks | 60% | $140,000 | 70% | $120,000 | Sell $20,000 |
| Bonds | 30% | $42,000 | 21% | $60,000 | Buy $18,000 |
| Cash | 10% | $18,000 | 9% | $20,000 | Buy $2,000 |
| Total | 100% | $200,000 | 100% | $200,000 | Net zero |
When to Rebalance Your Portfolio
Use one of these approaches to determine when to rebalance:
- Calendar-based (annually): Review and rebalance once per year on a fixed date. This is the simplest approach and works well for most investors. January or your birthday are easy dates to remember
- Threshold-based (5% drift): Rebalance whenever any asset class drifts more than 5 percentage points from its target. This responds to market conditions but requires monitoring
- When making new contributions: Direct new investment dollars into the underweighted asset class to gradually restore your target allocation without selling anything
- After major life events: Marriage, divorce, inheritance, job change, or approaching retirement should trigger a full portfolio review and potential reallocation
- During tax-loss harvesting: Combine rebalancing with tax-loss harvesting in taxable accounts to offset capital gains with losses from underperforming positions
Common Rebalancing Mistakes
Avoid these errors when rebalancing your portfolio:
- Rebalancing too frequently: Monthly or quarterly rebalancing generates unnecessary transaction costs and tax events. Annual rebalancing or threshold-based rebalancing (at 5% drift) is sufficient for most investors
- Ignoring tax consequences: In taxable accounts, selling appreciated assets triggers capital gains taxes. Prefer rebalancing in tax-advantaged accounts (401(k), IRA) where there are no tax consequences
- Emotional resistance to selling winners: Rebalancing requires selling your best-performing assets and buying the worst-performing ones. This feels counterintuitive but enforces buy-low, sell-high discipline over time
- Forgetting to rebalance across all accounts: View your total portfolio holistically across all accounts. You may be able to rebalance by adjusting allocations within tax-advantaged accounts without triggering taxes in taxable ones
- Abandoning rebalancing during bear markets: Rebalancing into stocks during a downturn feels scary but historically produces the best long-term results. This is when the buy-low benefit is greatest
Rebalancing is a simple but powerful discipline that keeps your portfolio aligned with your risk tolerance and financial goals. Set a calendar reminder to review your portfolio once a year, rebalance when any asset class drifts more than 5% from its target, and prefer rebalancing within tax-advantaged accounts. If you want fully automatic rebalancing, target-date funds handle it for you.
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Common questions
Frequently asked questions
Does rebalancing improve returns?
Rebalancing primarily manages risk rather than boosting returns. In strongly trending markets, a never-rebalanced portfolio may produce slightly higher total returns (because stocks outperform bonds over long periods). However, rebalancing significantly improves risk-adjusted returns and prevents your portfolio from becoming riskier than intended. It also enforces the discipline of buying low and selling high.
How do I rebalance without selling?
You can rebalance by directing new contributions to underweighted asset classes. For example, if stocks have grown to 75% of your portfolio against a 60% target, direct all new contributions to bonds and cash until your allocation returns to target. This cash flow rebalancing avoids selling (and potential taxes) while gradually restoring your desired mix.
Do target-date funds rebalance automatically?
Yes. Target-date funds automatically rebalance to maintain their target allocation and gradually shift toward a more conservative mix as you approach retirement. This is one of their primary advantages. If you invest in a target-date fund, you do not need to rebalance manually, which makes them an excellent choice for investors who prefer a hands-off approach.
Evidence you can inspect
Sources and further reading
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