Financial Education Series

Portfolio Rebalancing

Maintaining Your Target Asset Allocation

Portfolio rebalancing is the process of realigning the weightings of assets in your investment portfolio to maintain your original desired level of asset allocation. It's an essential risk management strategy that helps ensure your investments remain aligned with your long-term goals and risk tolerance.

Why Rebalance Your Portfolio?

Key Benefits

Risk Management

Over time, as different assets perform differently, your portfolio can drift from your original target allocation, potentially exposing you to more risk than you intended.

Helps maintain your desired risk level

Prevents overexposure to any single asset class

Reduces vulnerability to market volatility

Buy Low, Sell High

Rebalancing inherently encourages buying assets that have decreased in value and selling those that have increased—effectively implementing the "buy low, sell high" principle.

Forces disciplined investing

Removes emotional decision-making

Can enhance long-term returns through systematic profit-taking

Long-term Focus

Regular rebalancing keeps your portfolio aligned with your investment time horizon and financial goals.

Ensures alignment with your investment plan

Provides opportunity to reassess goals periodically

Accommodates changes in risk tolerance as life circumstances evolve

Rebalancing Methods

Different Approaches

Calendar Rebalancing

Adjusting your portfolio at predetermined time intervals.

Most common: Quarterly, semi-annually, or annually

Benefits: Simple, disciplined approach with less monitoring required

Drawbacks: Might miss significant market moves between rebalancing dates

Percentage-of-Portfolio Rebalancing

Rebalance when asset allocations drift beyond predetermined thresholds.

Common threshold: 5% deviation from target allocation

Benefits: Responds to market movements, potentially reducing transaction costs

Drawbacks: Requires more frequent monitoring

Tactical Rebalancing

Intentionally deviating from target allocations based on market outlook.

Approach: Temporarily overweight/underweight certain assets

Benefits: Potential to capitalize on short-term market opportunities

Drawbacks: Requires market timing skill; increases risk of mistakes

Cash Flow Rebalancing

Using new contributions or withdrawals to adjust portfolio allocations.

Contributions: Direct new money to underweight assets

Withdrawals: Take funds from overweight assets

Benefits: Minimizes transaction costs and potential tax consequences

Practical Considerations

Implementation Factors

Transaction Costs

Every trade incurs costs, whether through commissions, bid-ask spreads, or potential tax implications. Consider these when determining your rebalancing frequency and method.

Rebalance less frequently to minimize trading costs

Consider using no-transaction-fee funds or commission-free ETFs

Tax Implications

Rebalancing in taxable accounts can trigger capital gains taxes. Strategic approaches can help minimize the tax impact.

Prioritize rebalancing in tax-advantaged accounts (IRAs, 401(k)s)

Use new contributions to rebalance taxable accounts

Consider tax-loss harvesting opportunities during rebalancing

Rebalancing Bands

Setting appropriate thresholds for when to rebalance can help balance risk management and efficiency.

Narrower bands (e.g., 3-5%) maintain tighter risk control but increase trading frequency

Wider bands (e.g., 7-10%) reduce trading but allow more drift from target allocation

Consider different bands for different asset classes based on volatility

Automation

Many investment platforms offer automatic rebalancing services, simplifying the process.

Robo-advisors typically include automatic rebalancing

Some 401(k) plans and brokerages offer automatic rebalancing features

Target-date funds automatically adjust allocations over time

Rebalancing Example

Portfolio Rebalancing in Action

Initial Portfolio

Michael starts with a $100,000 portfolio with a target allocation of 60% stocks, 30% bonds, and 10% cash.

Stocks

$60,000 (60%)

Bonds

$30,000 (30%)

Cash

$10,000 (10%)

One Year Later

After a year of strong stock market performance, Michael's portfolio has grown to $120,000, but the allocations have shifted.

Stocks

$84,000 (70%)

Bonds

$30,000 (25%)

Cash

$6,000 (5%)

Rebalancing Actions

To return to his target allocation, Michael needs to make the following adjustments:

Sell $12,000 of stocks (reducing from $84,000 to $72,000 or 60%)
Buy $6,000 of bonds (increasing from $30,000 to $36,000 or 30%)
Add $6,000 to cash (increasing from $6,000 to $12,000 or 10%)

The Result

After rebalancing, Michael's portfolio is back to his target allocation, but at the higher overall value:

Stocks

$72,000 (60%)

Bonds

$36,000 (30%)

Cash

$12,000 (10%)

By rebalancing, Michael has taken profits from his stock gains and reinvested in underperforming assets, maintaining his desired risk level while enforcing the "buy low, sell high" discipline.

Best Practices

1. Create a written investment policy. Document your target asset allocation, rebalancing thresholds, and frequency to remove emotion from the process.

2. Consider your entire portfolio holistically. Look across all accounts (taxable and tax-advantaged) when determining if rebalancing is needed.

3. Be strategic about where to rebalance. Prioritize tax-advantaged accounts for selling appreciated assets to avoid capital gains taxes.

4. Reassess your target allocation periodically. As you age or your circumstances change, your ideal asset allocation may need adjustment.

5. Keep good records. Track your rebalancing activity for tax purposes and to evaluate the effectiveness of your approach over time.

This article is for educational purposes only and updated as of August 2024. Rebalancing strategies should be tailored to your individual financial situation, investment goals, and tax considerations. Consider consulting with a financial advisor before implementing any rebalancing strategy.