Rebalancing

What Is Rebalancing?

Rebalancing is the practice of adjusting a portfolio back to its intended allocation. An investor first chooses a target mix, such as a set percentage in stocks and another in bonds. Over time, the assets grow or shrink at different rates, so the actual weights drift away from that plan. Rebalancing brings the weights back in line by selling some of the holdings that have grown larger and buying more of those that have fallen behind.

How It Works

Suppose an investor starts with a portfolio split 60% stocks and 40% bonds. If stocks rise strongly while bonds stay flat, the portfolio might end up at 70% stocks and 30% bonds. To rebalance, the investor sells enough stock to reduce that position and uses the proceeds to buy bonds, restoring the 60/40 split. The portfolio's risk profile, which depends heavily on this mix, stays closer to what the investor originally intended.

Rebalancing can be done on a calendar schedule, such as once a year, or when allocations move beyond a set tolerance band, such as five percentage points away from target. Many investors combine both approaches.

Advantages and Disadvantages

Rebalancing helps keep risk from creeping up unnoticed. An investor who lets winning assets run without limit may end up holding far more risk than planned, which can be a problem during a downturn. The process also imposes a sell-high, buy-low discipline, since it trims positions that have risen and adds to those that have lagged.

There are drawbacks. Selling assets can trigger capital gains tax in taxable accounts, and each trade may carry transaction costs. Frequent rebalancing can add expense without much benefit. Rebalancing also does not guarantee higher returns, and in strong trending markets, a portfolio that is not rebalanced may outperform one that is.

Why It Matters to Investors

Rebalancing is a way to manage the risk of a portfolio rather than a method for predicting markets. Because it is rule-based, it reduces the influence of emotional decisions. Investors often use new contributions to rebalance, directing fresh money toward underweight assets, which can reduce the need to sell. Understanding the trade-offs between rebalancing frequency, costs and taxes helps investors decide how to apply it within their own circumstances.