Portfolio rebalancing is a powerful yet often overlooked tool for managing risk and optimizing returns, which involves realigning your investments with your intended target mix. When your investments drift off course, you could expose yourself to more risk than you intended or miss key opportunities.
This post will show you exactly how to rebalance your portfolio effectively and provide a quick refresher on asset allocation.
How to Rebalance Your Portfolio
Let me walk you through the different methods you can use, from hands-on approaches to completely automated solutions.
Manual portfolio rebalancing steps
When it comes to maintaining your target asset allocation, there are two main approaches to manual rebalancing, each with its own advantages.
Method 1 involves annual rebalancing–this more disciplined approach typically yields better long-term returns. Once per year, you calculate your current portfolio percentages, compare them against your target allocation, and sell overweight positions to buy underweight ones. While this method requires more discipline and can feel counterintuitive (especially when selling winners), it enforces a strict “buy low, sell high” strategy that can enhance returns over time.
Method 2 takes a more flexible approach through cash flow rebalancing. Here, you direct new investments toward underweight asset classes whenever you have cash. This method is easier to stick to and requires less active management. However, since you’re not actively selling overweight positions, your winners may continue to become a larger portion of your portfolio than intended. Basically, you won’t be “buying low and selling high” as often as Method 1.
If you’re new to investing, start with my guide to master the fundamentals before diving into rebalancing strategies: Investing for Beginners: A Quick and Easy Guide to Investment.
Using automation tools
Portfolio management software has made rebalancing significantly easier than it was even a few years ago. Popular platforms like Quicken, Sharesight, and Empower can automatically calculate drift and suggest specific trades needed for rebalancing. Many of these tools can track investments across multiple accounts and providers, making it simple to maintain a balanced portfolio even with complex financial situations.
The real power comes from setting up alerts when your portfolio drifts beyond predetermined thresholds. This removes the emotional aspect of decision-making and ensures you stay on top of necessary adjustments.
Look for platforms that provide tax-aware rebalancing features–these can help minimize tax implications while maintaining your desired asset allocation. The best tools will also automatically reinvest dividends and capital gains in underweight asset classes to maintain balance with minimal trading costs.
Target date funds approach
Target date funds offer a completely hands-off approach to rebalancing by automatically adjusting their asset allocation over time, becoming more conservative as you approach retirement. While this built-in rebalancing can simplify portfolio management significantly, evaluating whether a target date fund aligns with your risk tolerance and investment goals is crucial.
The costs associated with target date funds deserve careful consideration. A typical target date fund might charge a 0.75% expense ratio while managing individual index funds for rebalancing could cost as little as 0.05-0.15%.
Additionally, some target date funds have underlying fees that aren’t immediately obvious in the main expense ratio, potentially adding another 0.2-0.3% to your total costs. On a $100,000 investment, the difference between a 0.75% target date fund ($750/year) and a self-managed portfolio of low-cost funds at 0.15% ($150/year) could save you $600 annually. However, you’ll need to weigh these savings against any trading costs and time spent on manual rebalancing.
Want to learn more about using technology to optimize your finances? Check out my guide, Automate Your Finances Using Technology and Psychology, to see how automation can transform your finances.
Tax-Efficient Rebalancing Strategies
Prioritize rebalancing within tax-advantaged accounts like 401(k)s and IRAs to avoid triggering taxable events. This allows you to make necessary adjustments without immediate tax consequences. Instead of selling positions in taxable accounts, use new contributions to rebalance whenever possible–directing fresh money to underweight asset classes rather than selling overweight positions minimizes both taxes and transaction costs.
Strategic timing around tax-advantaged opportunities can significantly reduce your tax burden. Consider aligning your rebalancing with qualified dividend payments or waiting for long-term capital gains treatment before making adjustments.
What Happens When You Ignore Portfolio Rebalancing
While rebalancing might seem like an optional task you can put off, the consequences of neglecting your portfolio can be severe. Let’s look at the specific risks you face when you let your investments drift off course.
Increased Risk Exposure
Over time, certain assets may outperform others, causing your portfolio to drift from its original allocation. This can increase exposure to riskier assets beyond your comfort level or goals.
The tech boom of the late 1990s provides a perfect example–investors who didn’t rebalance found themselves with 70-80% of their portfolio in technology stocks by 2000, just before the crash. The risk compounds because overweight positions often occur in assets that have become overvalued, essentially doubling your risk exposure through both allocation size and valuation levels.
Potentially Lower Returns
As certain assets grow disproportionately, they may become overvalued. This means you could miss out on gains from undervalued or underrepresented assets that are more aligned with market opportunities.
Historical data shows that regular rebalancing would have helped investors capitalize on opportunities like buying stocks at low prices in 2009 or reducing exposure to overvalued assets in 2021. The natural cycle of rebalancing forces you to “buy low and sell high” automatically rather than following market sentiment, which often leads to the opposite behavior.
Reduced Diversification
Not rebalancing can lead to an unbalanced portfolio, reducing the protective benefits of diversification and making your investments more susceptible to market volatility.
Consider a portfolio that started with 60% stocks and 40% bonds–after a long bull market, it might drift to 80% stocks and 20% bonds, dramatically increasing potential losses during market corrections. Different asset classes tend to perform differently during various economic conditions–proper diversification helps ensure you’re positioned to weather any market environment.
Misalignment with Financial Goals
Your investment objectives may evolve, and your portfolio should reflect that. Without rebalancing, your portfolio may no longer align with your financial goals or timeline. Life changes like approaching retirement, having children, or buying a house often require portfolio adjustments.
Regular rebalancing provides natural checkpoints to reassess these goals. The risk of misalignment compounds over time–a portfolio that’s 5% off target today could be 20% off target in a few years, potentially derailing long-term financial plans.
Emotional Investing Risks
If you don’t rebalance, you may be more prone to emotional investing decisions, like selling during downturns or buying high. Regular rebalancing creates a systematic process that removes emotion from investing decisions. This is particularly valuable during market extremes when emotions run highest.
Tax Implications
While rebalancing can trigger taxes, leaving a portfolio unbalanced may lead to unexpected tax implications if certain assets grow disproportionately and create taxable events upon eventual sale. Large, concentrated positions often lead to bigger tax bills when they eventually need to be sold. Strategic rebalancing in tax-advantaged accounts can help minimize tax implications while maintaining proper asset allocation across your entire portfolio.
Consider this example: selling 10% each year for rebalancing purposes may be more tax-efficient than being forced to sell 50% all at once due to risk concerns.
When Portfolio Rebalancing Matters
Now that you understand the risks of not rebalancing let’s talk about timing. When exactly should you make these adjustments to keep your portfolio on track?
Time-based vs threshold-based rebalancing
There are two primary approaches to determining when you should rebalance your portfolio: time- and threshold-based rebalancing. Let’s break down the key differences between these methods to help you choose the best solution.
Time-based rebalancing operates on a fixed schedule, typically annual, making it simple to implement and track. It’s ideal for hands-off investors who prefer routine and easy to automate and maintain. However, this approach may trigger unnecessary trades and might miss significant market shifts.
Threshold-based rebalancing triggers when allocations drift beyond set percentages (5-10%). This method requires more frequent monitoring and attention but usually results in fewer trades overall. It’s better suited for active investors who watch their portfolios closely and offers more responsiveness to market movements, though it requires more effort.
Both approaches have clear trade-offs in terms of complexity, cost, and effectiveness. Your choice should align with your investment style and how actively you want to manage your portfolio.
While a simple comparison might make threshold-based rebalancing seem more sophisticated, here’s what I’ve found after years of teaching this: the best ‘time’ to rebalance your portfolio is to do it consistently, once a year. Choose a method you can stick to the easiest and don’t get bogged down by any other complexities.
Signs your portfolio needs rebalancing
Beyond your regular scheduled rebalancing, certain situations should trigger an immediate portfolio review. While there are many potential indicators, here are the most critical signs that it’s time to rebalance:
- Your current asset allocation has significantly drifted from your targets. For example, if your intended 60/40 stock-to-bond ratio has shifted to 75/25 due to strong market performance, you’re taking on substantially more risk than planned without realizing it.
- Major life changes have shifted your financial goals or risk tolerance. Events like marriage, having children, changing careers, or approaching retirement within 5-10 years often require a fundamental reassessment of your investment strategy.
- Your portfolio’s overall volatility has increased noticeably, causing you stress or anxiety about your investments. This often indicates that riskier assets have become overweight and need to be trimmed back to maintain your desired risk level.
- Significant market events or sector movements have occurred, like if technology stocks have doubled while other sectors remained flat, your technology exposure might now be disproportionately large compared to your original allocation.
These warning signs deserve immediate attention, even if you’re not due for your regular rebalancing check-in. The key is recognizing these signals early and taking action before small imbalances become major portfolio risks.
Optimal rebalancing frequency
Let’s be practical: rebalancing too frequently (monthly or more) often increases costs without significant benefits. It would be wise to just rebalance your portfolio annually. When determining your rebalancing frequency, consider your investment costs–accounts with no transaction fees can be rebalanced more often than those with trading costs.
Factor in tax implications as well. Taxable accounts might benefit from less frequent rebalancing to minimize taxable events, while tax-advantaged accounts can be rebalanced more regularly. Large market moves might necessitate off-schedule rebalancing. For example, during the March 2020 market crash, rebalanced investors captured significant gains in the subsequent recovery.
Market timing considerations
This might be the most important thing I’ll tell you about rebalancing: avoid trying to time the market with your rebalancing schedule. The goal is to maintain your target allocation rather than to predict market movements. Many investors get caught up trying to pick the “perfect” time to rebalance, often leading to paralysis or missed opportunities.
During periods of high market volatility, consider implementing a systematic rebalancing approach by spreading trades over several weeks rather than making all changes at once. Be particularly aware of dividend and capital gains distribution schedules when rebalancing mutual funds–rebalancing just before a distribution could create unnecessary tax consequences.
During extreme market conditions, wider rebalancing bands (7-10% instead of 5%) might be useful to avoid excessive trading. Regular contributions or withdrawals can serve as natural rebalancing opportunities, reducing the need for separate rebalancing trades during market extremes.
Understanding Asset Allocation Basics
Before diving deeper into rebalancing strategies, it’s crucial to understand what you’re actually balancing. Let’s break down the building blocks of a well-diversified portfolio.
Different asset classes explained
Think of asset classes as the fundamental building blocks of your investment portfolio. Each serves a specific purpose, like ingredients in a recipe that come together to create a balanced meal. Here are the main asset classes you’ll work with:
- Stocks (equities) represent ownership in companies and typically offer the highest potential returns but also the most volatility. Different subcategories, such as large-cap, small-cap, international, and emerging markets, each play distinct roles in a portfolio.
- Bonds (fixed income) provide regular income and stability but generally lower returns than stocks. They range from ultra-safe government bonds to higher-yielding corporate and high-yield bonds, each with different risk-return profiles.
- Cash and cash equivalents offer the highest safety but lowest returns. This category includes savings accounts, money market funds, and short-term government securities–crucial for emergency funds and short-term goals.
- Alternative investments like real estate, commodities, and cryptocurrencies can provide additional diversification but often come with unique risks and complexities. These should typically comprise a smaller portion of most portfolios.
Understanding these different asset classes and how they work together is crucial for maintaining a well-balanced portfolio. Each plays its own role in your investment strategy, and the right mix depends on your personal goals and risk tolerance.
Target allocation ratios
The next crucial step is determining how much of each you should own. While there’s no one-size-fits-all solution, several tried-and-true guidelines can help you find your optimal mix.
The classic “110 or 120 minus your age” rule provides a simple starting point. For example, a 40-year-old might aim for 70-80% stocks. From there, investors typically fall into three main categories: Conservative portfolios start with a 30/70 stock/bond split, moderate portfolios hover around 60/40, and aggressive portfolios push toward 80/20 or higher.
Consider your “human capital” when setting these ratios. Younger investors with stable jobs can often take more risk since their future earning potential acts as a “bond-like” asset in their overall financial picture. International exposure typically ranges from 20% to 40% of your portfolio’s stock portion, providing geographical diversification and exposure to different economic cycles.
How allocations drift over time
Market performance naturally causes portfolio drift – during the 2010s, a standard 60/40 portfolio would have drifted to roughly 75/25 without rebalancing due to strong stock market performance. Different assets grow at different rates; growth stocks might outperform value stocks for extended periods, causing sector imbalances within your equity allocation.
Compound returns amplify this drift over time. Even small annual differences in returns between asset classes can lead to significant allocation changes over 5-10 years. Economic cycles affect different assets differently–during inflationary periods, certain assets like TIPS and commodities might grow disproportionately, requiring more frequent rebalancing.
Smart Portfolio Rebalancing Strategies
Let’s explore some good ways to keep your portfolio balanced while minimizing costs and maximizing efficiency.
Using new contributions
Direct new investments strategically to underweight asset classes. This approach minimizes transaction costs and tax implications since you’re not selling existing positions to rebalance. Setting up automatic investment plans that adjust contribution allocations based on your current portfolio balance makes this even easier.
Dollar-cost averaging through regular contributions naturally helps rebalance during market volatility. This approach is particularly practical in workplace retirement accounts where you make consistent contributions. Consider setting up “distribution rebalancing” in retirement accounts, where dividends and capital gains automatically reinvest into underweight assets rather than their source funds.
Minimizing transaction costs
While transaction costs have decreased significantly in recent years, they can still eat into your returns if you’re not careful. Here are the key strategies to keep these costs as low as possible:
- Prioritize rebalancing in accounts with no transaction fees or commission-free ETFs. Many brokerages now offer free trading, making this easier than ever. When possible, bundle multiple rebalancing trades together to reduce overall transaction costs.
- Use ETFs instead of mutual funds when possible for rebalancing. ETFs typically have lower transaction costs and no minimum holding periods or redemption fees, giving you more flexibility in your rebalancing strategy.
- Consider using broad-market index funds that require fewer individual transactions to maintain proper diversification. One total market fund can replace multiple sector-specific funds, significantly reducing the number of trades needed to maintain balance.
These strategic approaches to minimizing costs can save you thousands of dollars over time while keeping your portfolio properly balanced.
Tax-loss harvesting opportunities
Consider tax-loss harvesting opportunities during rebalancing, especially in taxable accounts. This can help offset gains while maintaining your desired asset allocation. It’s definitely becoming more popular, and some advisors and robo-advisors even have it built in. For example, Betterment and Wealthfront both have tax-loss harvesting features that help out a lot.
Consider using specific tax lots when selling to maximize tax efficiency, as some positions might have higher cost bases that can minimize capital gains when sold.
Rebalancing across multiple accounts
When rebalancing, view all your investment accounts as one portfolio. This “household-level” approach can be more tax-efficient and reduce overall trading costs. Hold tax-efficient investments like stock index funds in taxable accounts and tax-inefficient investments like bonds in tax-advantaged accounts. This location optimization can significantly impact after-tax returns.
Create an “investment map” showing where each asset class should be held across accounts. This helps maintain proper asset location while rebalancing. Use specialized portfolio management software to help coordinate rebalancing across multiple accounts and accurately track your overall asset allocation.
Automating Your Portfolio Rebalancing
Let’s talk about how to make this entire process run on autopilot – because the best rebalancing strategy is one you’ll actually stick to.
Robo-advisor options
If you want a completely hands-off approach, robo-advisors have revolutionized portfolio management. These digital platforms offer fully automated rebalancing, typically charging between 0.25% and 0.65% annually. Popular options like Betterment and Wealthfront monitor your portfolio daily and automatically rebalance when allocations drift beyond set thresholds.
What makes these platforms particularly powerful is their sophisticated approach to tax efficiency. They use algorithms to minimize tax impact through tax-loss harvesting and intelligent dividend reinvestment. Some even coordinate across multiple account types for optimal tax efficiency. Just keep in mind that this convenience comes with a trade-off–most robo-advisors limit your investment choices to pre-selected ETF portfolios.
Target date funds
For those seeking ultimate simplicity, target date funds offer a true “set it and forget it” solution. These funds automatically rebalance and adjust their allocation as you approach retirement, becoming more conservative over time. One simple investment provides complete diversification and automatic rebalancing.
The key here is choosing low-cost options. Providers like Vanguard or Fidelity offer target date funds with total expenses as low as 0.08-0.15% annually–significantly cheaper than most actively managed alternatives. This makes them an attractive option for hands-off investors who still want to keep costs low.
Auto-rebalancing features
Many investors don’t realize that their existing brokerage might already offer powerful automation tools. Modern platforms like M1 Finance have built-in auto-rebalancing features at no additional cost, allowing you to set target allocations and automatically rebalance with new contributions or on a schedule.
Take a few minutes to check if your 401(k) provider offers automatic rebalancing – many do, but it’s often an opt-in feature that needs to be manually enabled.
Set-it-and-forget-it approaches
The ultimate form of portfolio automation comes from creating a system so simple it almost runs itself. Here’s what that looks like in practice:
- Build a low-maintenance portfolio using just 2-3 broad-market index funds (like a total US market fund, international fund, and bond fund). This provides complete diversification without the complexity of managing dozens of positions.
- Set up auto-investment features that regularly add money to your target allocation. Most modern brokerages let you schedule automatic investments with your preferred allocation, eliminating the need to manually invest each month.
- Create calendar reminders for quarterly or annual portfolio reviews–while “set it and forget it” doesn’t mean “never look at it,” you really only need to check in periodically to ensure everything is running smoothly.
Investing and portfolio rebalancing is just one step towards your Rich Life. While automation makes the process easier, you still need a solid foundation in personal finance basics like building a sustainable Conscious Spending Plan and understanding asset allocation.
To learn more about creating your complete financial system, check out my NYT Bestselling book, I Will Teach You To Be Rich, the goal isn’t just to have a perfectly balanced portfolio–it’s to use these tools and strategies to create the life you want.
