Rebalancing means selling a bit of what has grown too large and adding to what has shrunk, so your portfolio returns to the mix you chose. Its main purpose is to control risk, not to boost returns.
Why portfolios drift
Say you start at 70% stocks and 30% bonds with $100,000. Stocks rise 20% in a year and bonds stay flat. You now have $84,000 in stocks and $30,000 in bonds: about 74% / 26%. After a few strong years you could be at 80% stocks without ever deciding to take that much risk. When the next downturn comes, it hits harder than you planned for.
Two common methods
Calendar rebalancing. Check once a year (a birthday, or tax time) and reset the mix. Simple and hard to forget.
Threshold rebalancing. Rebalance only when an asset class moves more than a set amount from target, for example 5 percentage points. This trades less in calm years and reacts when markets move a lot.
Many people combine them: look once a year, act only if the drift is meaningful. Rebalancing monthly is unnecessary and can add costs.
The easiest way: use new money
Instead of selling, direct new contributions to whatever is underweight. If stocks have run ahead, put the next several months of contributions into bonds. This avoids selling, and in taxable accounts it avoids capital gains.
Mind taxes
- Inside 401(k)s and IRAs, buying and selling triggers no tax, so rebalance there first.
- In taxable accounts, selling winners can create capital gains. Prefer using new money or dividends, and see how capital gains are taxed.
- Rebalancing can also be a moment to harvest losses on positions that have fallen.
Step by step
- Write down your target mix (see asset allocation).
- Add up the current value of each asset class across all accounts.
- Compare with targets and note the gaps.
- Close the gaps with new money first, then trades inside tax-advantaged accounts, then taxable sales if still needed.
Hands-off options
Target-date funds and balanced funds rebalance internally, and most robo-advisors do it automatically. Rebalancing feels uncomfortable because it means buying what has recently done worst. That discipline is the point. The SEC’s Investor.gov page on asset allocation covers rebalancing too.
