Portfolio Rebalancing: Why, When, and How

Investing can be pretty simple — just pick a few index funds and decide how much of each asset class (e.g. stocks, bonds) to own based on your risk tolerance. Then you can forget about your portfolio and think about more important things in life.

However, even a simple hands-off portfolio needs some periodic maintenance. Market movements can cause your asset allocation to shift away from your original allocation. When this happens, rebalancing your portfolio resets your portfolio back to the way you want it.

Why Rebalance?

The goal of portfolio rebalancing is to ensure that you maintain a relatively constant asset allocation over time. When you initially form your portfolio, you’ve made a decision about how much risk you want to take with your investments. For some investors, that means lots of stocks. For others, that means more bonds.

But the gyrations of the stock market and bond markets can tilt the balance of your portfolio.

Example

Let’s say that you invested in a portfolio of 50% U.S. stocks and 50% U.S. bonds in 2009. This is a pretty conservative portfolio that might be appropriate for an investor who is retired. In the past 8 years, the stock market has vastly outperformed the bond market. with the U.S. Stock market returning 14.8% and the bond market returning 3,8% since 2009, according to Portfolio Visualizer.

If you never rebalanced your portfolio, your 50/50 stock/bond portfolio in 2009 would be a 70/30 portfolio today. This is a much more aggressive portfolio, and a retired investor who preferred a 50/50 portfolio would not want this type of asset allocation. To avoid this scenario, periodic portfolio rebalancing could have been done to re-establish a 50/50 portfolio. To rebalance this portfolio, you would be selling stocks and buying bonds.

Portfolio rebalancing is not about trying to beat the market

It is important to remember that portfolio rebalancing is not about market timing. Selling asset classes that have risen and buying asset classes that have fallen is a natural consequence of regular portfolio rebalancing.

While you are “buying low and selling high,” the current bull market is an example of where rebalancing could actually hurt your overall returns. While you may have bought low and sold high, unfortunately the U.S. stock market has gone even higher. However, the purpose of rebalancing is to maintain an asset allocation that fits your appetite for risk, not maximizing your returns.

In our retiree’s example, maximizing his or her investment returns would consist of holding a 100% stock portfolio. Since a 100% stock portfolio has too much risk for the retiree, he or she has consciously chosen a more conservative 50/50 portfolio. Rebalancing ensures that the portfolio remains at that more conservative 50/50 allocation.

How Often Should You Rebalance Your Portfolio?

Investors often ask how frequently to rebalance their portfolios. There are two major approaches, time-based rebalancing and percentage-based rebalancing, but remember that there is no “right” frequency for everyone. It is about personal preference.

Time-based rebalancing (e.g. annually, quarterly)

The first approach to portfolio rebalancing is to simply do it at regularly scheduled intervals. Some investors may rebalance quarterly, but re-balancing annually is completely reasonable as well.

One of the benefits of rebalancing on a periodic basis is that it enables you to avoid looking at the markets on a regular basis. Using time-based rebalancing, you could potentially avoid looking at your portfolio for months at a time. When it’s time for your regular portfolio check-up every quarter or every year, you would rebalance your portfolio back to your desired asset allocation.

Rebalance with every paycheck

A variant on time-based rebalancing is to rebalance your portfolio with every paycheck. Let’s say that you get your paycheck every month, and you save some of that money and invest it in the market. Instead of automatically investing your paycheck into the same mutual funds each month, you could calculate your current asset allocation and rebalance accordingly.

For example, if you want a 50/50 portfolio, but at the end of the month, your portfolio is 52/48 in favor of stocks, you could put that month’s paycheck into bonds to rebalance your portfolio back to a 50/50 allocation.

This method enables you to avoid selling shares in order to rebalance. As a result, you avoid the commissions and possible taxes associated with selling.

Percentage-based rebalancing

An alternative approach to portfolio rebalancing is to only rebalance when your asset allocation is significantly different from your desired allocation. For example, if you desire a 50/50 allocation, you may choose to only rebalance when your portfolio is more than 5% different from your target allocation (e.g. 55/45 or 45/55 stocks/bonds).

Using this method, you could potentially avoid rebalancing your portfolio for a very long period of time if the market is not very volatile.

The downside of this approach is that you need to check if your portfolio needs rebalancing relatively frequently.

What about target-date funds?

For the hands-off investor who chooses to invest in target-date funds, portfolio rebalancing is not necessary. Target-date funds will rebalance your portfolio for you.

How To Rebalance Your Portfolio

With each new paycheck, add money in the appropriate asset classes to rebalance your portfolio

For younger investors who are saving a portion of every paycheck, my favored approach is to check your asset allocation each month and rebalance your portfolio by investing in the under-allocated parts of the portfolio.

You don’t have to do this with every paycheck. For example, if you prefer a 50/50 allocation, you could invest most paychecks at 50/50, but periodically, you could check your allocation and see if it is unbalanced. If it were 52/48 in stocks, you could invest your next paycheck entirely into bonds to rebalance your portfolio back to 50/50.

Sell shares of overperforming asset classes, while buying shares of underperforming asset classes

An alternative approach is to sell shares of overperforming asset classes, and buy shares of underperforming asset classes. This is a less ideal approach, because it may incur extra commissions and potentially trigger taxable events. When possible, do your rebalancing (sell appreciated shares and buy declining shares) in your retirement and tax-deferred accounts, as trading gains and losses in these accounts are not taxable events. This is one reason why you need to choose your taxable asset allocation wisely; you want to be trading in taxable accounts as little as possible.

Conclusion

Rebalancing is an important part of portfolio maintenance for the do-it-yourself investor. Decide whether you want to rebalance on a scheduled basis (e.g. quarterly or annually) or only if your asset allocation deviates significantly from your desired asset allocation. Ideally, use your regular paycheck to rebalance your portfolio, and be careful about incurring taxable events when rebalancing. And if you don’t want to deal with portfolio rebalancing at all, invest in a target-date fund.

What do you think? How often do you rebalance your portfolio? Do you rebalance your portfolio using new money, or do you sell and buy shares within your retirement accounts? Do you have any additional rebalancing tips to share with the community?