What is Portfolio Rebalancing?
Portfolio rebalancing is the process of buying and selling assets to restore your investment portfolio to its original target allocation after market gains or losses have caused it to drift.
Portfolio rebalancing is the process of realigning your investment portfolio back to its original target asset allocation after market movements have shifted the mix. Over time, assets that perform well will grow to represent a larger share of your portfolio, while laggards shrink — pulling your actual allocation away from the intended one.
Rebalancing corrects this drift by selling some of what has grown and buying more of what has declined, maintaining the risk profile you originally intended.
Why Portfolios Drift
Consider a simple example. You start with a target of 70% stocks and 30% bonds. After a two-year bull market in stocks, your portfolio has drifted to 85% stocks and 15% bonds. You're now taking on significantly more risk than you planned — and if the market drops, you'll experience larger losses than your target allocation was designed to absorb.
Rebalancing would involve selling some stock holdings and buying bonds to return to 70/30.
Rebalancing Strategies
There are several common approaches:
Calendar rebalancing — Review and rebalance on a fixed schedule: quarterly, semi-annually, or annually. Simple to implement and easy to stick to.
Threshold (percentage) rebalancing — Rebalance whenever any asset class drifts more than a set percentage from the target (e.g., more than 5 percentage points). More responsive to actual market conditions but requires ongoing monitoring.
Hybrid approach — Review on a calendar schedule, but only rebalance if allocations have drifted beyond a threshold. This balances discipline with avoiding unnecessary trading.
The Tax Implications of Rebalancing
In a taxable brokerage account, selling appreciated assets to rebalance triggers capital gains taxes. This can reduce the effectiveness of rebalancing in taxable accounts. Strategies to minimize the tax impact:
- Rebalance primarily in tax-advantaged accounts — No taxes owed on trades within a Roth IRA or 401(k)
- Use new contributions to rebalance — Direct new money into underweight asset classes rather than selling overweight ones
- Tax-loss harvesting — Sell underperforming positions at a loss to offset gains from rebalancing
Does Rebalancing Improve Returns?
The primary purpose of rebalancing is risk management, not return enhancement. By systematically selling what has risen and buying what has fallen, rebalancing can capture a small "rebalancing bonus" over time — but this effect is modest and inconsistent. The bigger benefit is behavioral: rebalancing enforces discipline and prevents your portfolio from becoming unintentionally concentrated in whichever assets have recently performed best.
Rebalancing During Market Downturns
Rebalancing during a bear market can feel counterintuitive — you're essentially buying more of what's fallen. But this is exactly how rebalancing is supposed to work. Buying equities at lower prices lowers your average cost and positions you for stronger recovery when markets rebound. It's one of the few ways individual investors can systematically "buy low."