Portfolio Rebalancing: Maintaining Your Target Asset Allocation
Portfolio rebalancing is the disciplined process of periodically buying and selling portfolio holdings to restore your original target asset allocation, counteracting the natural drift that occurs as different investments deliver varying returns.
While conceptually simple, rebalancing embodies a contrarian investment discipline that forces investors to "buy low and sell high"—selling appreciated assets that have grown beyond their target allocation and purchasing underperforming assets that have fallen below target weights.
Consider a portfolio starting at 60% stocks and 40% bonds: if stocks surge 25% while bonds return 3%, the portfolio might drift to 68% stocks and 32% bonds, increasing risk beyond the investor's intended level.
Rebalancing would involve selling stocks and buying bonds to restore the 60/40 mix, capturing gains from the appreciation and preparing the portfolio for potential reversals.
Academic research consistently demonstrates that rebalancing enhances risk-adjusted returns over long periods, though the benefit varies with market conditions, rebalancing frequency, and the width of tolerance bands.
Vanguard research suggests that annual or semi-annual rebalancing with 5% tolerance bands (rebalancing when any asset class deviates more than 5 percentage points from target) provides an optimal balance between maintaining risk control and minimizing trading costs and tax consequences.
The rebalancing frequency question is important: daily rebalancing increases costs without meaningful benefit, while rebalancing only every 5-10 years allows substantial drift and risk misalignment.
Most financial advisors recommend quarterly reviews with rebalancing triggered when allocations drift beyond tolerance bands, or calendar-based rebalancing (annually or semi-annually) combined with opportunistic rebalancing during extreme market movements.
Tax-efficient rebalancing is crucial for taxable accounts: rather than selling appreciated positions and triggering capital gains taxes, investors can rebalance through new contributions directed to underweight asset classes, dividend reinvestment into underweight positions, or tax-loss harvesting to generate capital losses that offset necessary rebalancing sales.
In retirement accounts, rebalancing is simpler since transactions don't trigger tax consequences, allowing more aggressive rebalancing to maintain precise target allocations.
Modern portfolio theory suggests that rebalancing also provides a modest return enhancement ("rebalancing bonus") estimated at 0.4-0.6% annually, though this varies based on the volatility differential between asset classes and their correlation—highly volatile, low-correlation assets produce larger rebalancing benefits.