Rebalancing: What it means for investors and how it works

When you start investing, you might have an investment plan that defines your asset allocation. For example, your portfolio could contain 50% stocks and 50% bonds. As these assets grow or shrink in value at different rates, your portfolio may shift away from your original plan. This is known as portfolio drift.

So, rebalancing your portfolio means periodically buying and selling investments to bring it back in line with your target asset allocation. This strategy is linked to an investor’s risk tolerance and desire for reward.

Rebalancing your portfolio helps you stay on course with your investment strategy. The allocation of the different asset classes in your portfolio matches your risk tolerance. So, after any changes to your asset allocation, you may find you are exposed to more (or less) risk than you’re comfortable with. Rebalancing is important to return to the weighting of investments you started with.

Rebalancing can help you to:

• Manage risk by bringing your overall risk exposure back on track. This might be necessary when higher-risk investments grow as a percentage of your portfolio, which increases the portfolio’s overall risk as a result.

• Maintain returns potential. At some point, lower-risk investments might perform better due to a down market and therefore make up a larger percentage of your portfolio. Poorly performing stocks might mean your portfolio becomes heavy with cash investments, for example. Even if it can feel reassuring to hold these investments, they typically offer lower returns over long periods. Some investors try to maintain their return potential by reducing lower-risk investments and reinvesting in areas with higher growth potential.

• Stay diversified. As your asset allocation changes over time, some individual asset classes can end up occupying a large portion of your portfolio. Rebalancing can maintain diversification by ensuring that no single asset class dominates your portfolio.

• Avoid impulsive decisions. Some investors put aside assets when markets are on the decline and become more aggressive when markets are up. Rebalancing can help manage emotions affected by market swings and put investors back on track toward their investment target.

Rebalancing can serve as a counterbalance to the ups and downs in the markets. It comes into play when market movements have caused your asset allocation to shift. For example, if stocks outperform and become an outsized portion of your portfolio, you may sell some and reinvest in other asset classes like bonds or cash. Rebalancing stocks could also mean taking profits and reinvesting them into underweighted positions.

Rebalancing can be split into four steps:

1. Identify the current asset allocation
   By taking a close look at your portfolio, you can figure out how much each asset class takes up in your portfolio (as a percentage). You could classify each asset in terms of, say, U.S. stocks, international stocks, bonds, and short-term cash investments. Some investors also like to look into more detailed allocations, such as large companies versus small companies.

2. Compare current asset allocation with your target
   If you’ve never come up with an investment strategy, then this might be the right moment to do so. If you already have a targeted asset allocation, the second step in rebalancing is to line up your actual asset allocation against your targeted one. Which asset classes are now over target or under target?

3. Figure out how much to buy or sell of each position
   Now you have a clear view of your asset classes, you might start thinking about how much of each asset to sell or buy. Selling a portion of any investment that has grown too large and buying more of those that have become too small is the next step in rebalancing your portfolio. You can use the proceeds from overweighted assets or add new contributions to rebalance in a tax-efficient way.
4. Make the necessary trades for rebalancing
   As a final step, you bring your portfolio back in line with your targeted asset allocation. If you don’t have enough cash in your portfolio, you might need to sell a portion of the overweighted assets first in order to generate the cash needed to buy a portion of the underweighted or new assets. In taxable accounts, be aware of capital gains that may apply when selling investments that have gained value.

If you want to build more liquidity into your portfolio, read more about how to diversify your cash savings.

There’s no specific rule about how often to rebalance a portfolio. However, many investment professionals recommend rebalancing stocks and other assets regularly, typically every six to 12 months. If you’re working with a financial advisor, they can provide suggestions on when to rebalance your portfolio to meet your financial goals.

Here are some rebalancing approaches to consider:

• Rebalancing on a predetermined schedule, such as annually, quarterly, monthly, or other specified dates

• Rebalancing after exceeding a specific threshold, such as when allocations deviate by a specific percentage (e.g., +/- 5–10%) from the investment target

• Rebalancing by combining the calendar-based and threshold-based methods

Aside from the timing, there are several different ways of keeping your portfolio in balance.

• Constant-mix: Your asset allocation is steady, regardless of how the market is performing. If one section of your portfolio grows too large, you sell it down and buy more of the underweight assets to bring everything back in line.

• Cash-flow rebalancing: Instead of selling investments, you use new contributions or withdrawals to make adjustments. This is considered a tax-friendly option.

• Opportunistic rebalancing: Rather than sticking to a schedule, you rebalance when the market swings significantly. That way, you can take advantage of price movements and realign your portfolio when opportunities arise.

Rebalancing in a taxable account can trigger capital gains, especially if you’re selling investments that have grown in value. That’s why rebalancing is something often connected with tax-advantaged accounts like IRAs or 401(k)s.

With investing, it’s also important to keep any transaction fees and other costs in mind, as these can bring down any returns you make.

This also depends on individual preferences. Some investors like maintaining control of their accounts and rebalance their portfolios manually. There’s also the option of a robo-advisor or investment platform that rebalances automatically. Everything is monitored and adjusted behind the scenes, with no action needed on your part.

Generally, rebalancing can be quite straightforward, but it also becomes complex if you’re investing in a taxable account. Also, some investors worry about making mistakes or lack confidence in their investing decisions, which can make it stressful to execute trades. At this point, it might be a good decision to get help from an advisor. They can help you:

• Choose the right rebalancing method

• Manage emotional biases

• Build a long-term investment strategy

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The above article is intended to provide generalized financial information designed to educate a broad segment of the public; it does not give personalized tax, investment, legal, or other business and professional advice. Before taking any action, you should always seek the assistance of a professional who knows your particular situation for advice on taxes, your investments, the law, or any other business and professional matters that affect you and/or your business.