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Rebalancing: Definition, Example, and FAQs

What Is Rebalancing?

Rebalancing is a core practice within portfolio management where an investor adjusts the weightings of assets in an investment portfolio to restore them to their original or desired asset allocation. Over time, different asset classes perform unevenly, causing the portfolio's actual composition to drift away from its intended target allocation. For example, if equities significantly outperform bonds, a portfolio initially set at 60% equities and 40% bonds might naturally drift to 70% equities and 30% bonds. Rebalancing involves selling some of the outperforming assets (e.g., equities) and buying more of the underperforming assets (e.g., bonds) to bring the portfolio back into alignment with the investor's predetermined investment strategy and risk tolerance. This process helps manage risk and ensures the portfolio remains consistent with long-term investment goals.

History and Origin

The concept of maintaining a disciplined portfolio structure, which underpins rebalancing, gained significant traction with the advent of Modern Portfolio Theory (MPT). Developed by economist Harry Markowitz in his seminal 1952 paper, "Portfolio Selection," MPT emphasized the importance of viewing investments not in isolation but as part of an overall portfolio, focusing on the interplay of risk and return through diversification.⁴⁹, ⁵⁰, ⁵¹ While Markowitz's initial work didn't explicitly detail rebalancing as a standalone practice, his theories laid the groundwork for managing a portfolio's risk-return characteristics by maintaining a specific asset mix.⁴⁸ The practical application of rebalancing evolved as investors and financial advisors sought methods to keep portfolios aligned with MPT principles amidst fluctuating market conditions. Early forms of rebalancing, such as those used by Sir John Templeton in the 1940s, involved adjusting allocations based on market valuations, shifting between stocks and bonds to control risk. Today, it is a commonplace strategy to manage portfolio drift.

Key Takeaways

Rebalancing is the process of adjusting a portfolio's asset weights back to a predetermined target.
It helps maintain the desired risk tolerance and aligns the portfolio with long-term investment goals.
Rebalancing typically involves selling assets that have grown to become an overweight portion of the portfolio and buying assets that have become an underweight portion.
This disciplined approach helps counter the effects of market volatility and prevents a portfolio from inadvertently becoming too risky or too conservative.
While it may seem counterintuitive to sell winners and buy losers, rebalancing enforces a "buy low, sell high" discipline.

Formula and Calculation

Rebalancing does not involve a single, universally applied formula in the way a financial ratio might. Instead, it is a process of comparing current portfolio weights to desired target allocation percentages and then executing trades to close the deviation.

The steps generally involve:

Determine Current Weights: Calculate the current market value of each asset class (e.g., equities, bonds) within the portfolio and express them as a percentage of the total portfolio value.
Compare to Target Weights: Subtract the current percentage of each asset class from its desired target percentage.
Calculate Adjustment Amount: For each asset class, determine the dollar amount that needs to be sold or purchased to bring its weight back to the target.

Example:
Target Portfolio: 60% Equities, 40% Bonds
Current Portfolio Value: $100,000

Initial Allocation:

Equities: $60,000
Bonds: $40,000

After market movements:

Equities grow to $70,000
Bonds decline to $30,000
Total Portfolio Value: $100,000

Current Weights:

Equities: $70,000 / $100,000 = 70%
Bonds: $30,000 / $100,000 = 30%

To Rebalance:

Equities need to decrease from 70% to 60%, a 10% reduction of the total portfolio value.
- Amount to sell from Equities: (10% \times $100,000 = $10,000)
Bonds need to increase from 30% to 40%, a 10% increase of the total portfolio value.
- Amount to buy in Bonds: (10% \times $100,000 = $10,000)

By selling $10,000 of equities and buying $10,000 of bonds, the portfolio returns to its 60%/40% target.

Interpreting Rebalancing

Interpreting rebalancing involves understanding its purpose: to manage risk tolerance and stick to a long-term investment strategy, rather than to maximize short-term returns. When a portfolio drifts due to market movements, its inherent risk profile changes. For instance, an outperforming stock market might cause a portfolio to become heavily weighted in equities, increasing its exposure to potential downturns.⁴⁷ Rebalancing acts as a control mechanism, ensuring the portfolio's risk remains consistent with the investor's comfort level. It inherently forces an investor to "sell high" from overperforming assets and "buy low" from underperforming ones, which can be psychologically challenging but financially disciplined.⁴⁶ Regular rebalancing, therefore, is an active way to enforce the predetermined asset allocation that was originally designed to meet specific investment goals.

Hypothetical Example

Consider an investor, Alex, who starts with a portfolio of $100,000 with a target allocation of 70% equities (e.g., through an index fund) and 30% bonds.

Initial Portfolio:

Equities: $70,000
Bonds: $30,000
Total: $100,000

After one year of strong market performance, the equity portion of Alex's portfolio grows by 20%, while the bond portion remains flat.

Portfolio after one year (before rebalancing):

Equities: $70,000 * (1 + 0.20) = $84,000
Bonds: $30,000
Total: $114,000

New Weights:

Equities: $84,000 / $114,000 (\approx) 73.68%
Bonds: $30,000 / $114,000 (\approx) 26.32%

Alex's portfolio has drifted, with equities now representing a larger, riskier proportion than intended. To rebalance back to the 70%/30% target for the $114,000 portfolio:

Desired Amounts:

Equities: 70% of $114,000 = $79,800
Bonds: 30% of $114,000 = $34,200

Rebalancing Trades:

Sell Equities: $84,000 (current) - $79,800 (desired) = $4,200
Buy Bonds: $34,200 (desired) - $30,000 (current) = $4,200

By selling $4,200 of equities and using the proceeds to buy $4,200 of bonds, Alex restores the portfolio to its 70%/30% allocation, maintaining the intended risk tolerance.

Practical Applications

Rebalancing is a fundamental practice across various facets of finance and investing:

Individual Investor Portfolios: For individual investors, rebalancing is crucial for maintaining an appropriate risk tolerance over time. Without it, market performance can inadvertently shift a portfolio's asset allocation, potentially exposing the investor to more risk than desired, especially as they approach specific investment goals like retirement.⁴⁴, ⁴⁵
Robo-Advisors and Target-Date Funds: Many automated investment platforms and target-date mutual funds or Exchange-Traded Funds (ETFs) incorporate automatic rebalancing. These services are designed to systematically adjust allocations back to their glide path, reducing the need for manual intervention by the investor.
Institutional Investing: Large institutional investors, such as pension funds and endowments, rigorously adhere to rebalancing policies to ensure their vast portfolios remain aligned with their long-term liabilities and strategic objectives. This disciplined approach is critical for managing systemic risk exposure.
Risk Management: Fundamentally, rebalancing serves as a risk management tool. By systematically selling assets that have appreciated significantly and buying those that have underperformed, it prevents a portfolio from becoming overconcentrated in a single asset class, thereby reducing overall portfolio risk. Research Affiliates highlights that disciplined rebalancing can improve risk-adjusted returns over time.⁴², ⁴³
Behavioral Finance: Rebalancing provides a structured framework that helps investors avoid emotionally driven decisions, such as chasing returns in hot markets or panicking during downturns. It enforces a "buy low, sell high" mechanism.⁴¹

Limitations and Criticisms

While widely recognized as a beneficial portfolio management practice, rebalancing does have limitations and criticisms:

Transaction Costs: Each rebalancing trade incurs transaction costs, such as brokerage fees and bid-ask spreads. Frequent rebalancing, especially for portfolios with many holdings or high trading costs, can erode returns.³⁸, ³⁹, ⁴⁰
Tax Implications: In taxable accounts, selling appreciated assets during rebalancing can trigger capital gains taxes.³⁷ This tax drag can sometimes outweigh the benefits of rebalancing, particularly for short-term gains which are taxed at ordinary income rates.²⁸, ²⁹, ³⁰, ³¹, ³², ³³, ³⁴, ³⁵, ³⁶ Strategies to mitigate this include rebalancing within tax-advantaged accounts or by directing new contributions to underweight asset classes.²⁶, ²⁷
Opportunity Cost (Missed Gains): Rebalancing means selling assets that have performed well. If those assets continue to outperform after the rebalance, the investor might miss out on further gains, leading to an "opportunity cost."²⁴, ²⁵ Critics sometimes argue that in strong bull markets, a "buy and hold" strategy might outperform a rebalanced one by letting winners run.²³
No Guaranteed Outperformance: The primary goal of rebalancing is risk control, not necessarily maximizing returns. While some studies suggest it can enhance risk-adjusted returns, especially over long periods or in volatile markets, it does not guarantee higher absolute returns than an un-rebalanced portfolio.²¹, ²² The effectiveness can vary depending on market conditions and the specific rebalancing strategy employed.²⁰
Complexity for Large Portfolios: For investors managing multiple accounts or a complex mix of holdings, determining the optimal rebalancing trades to minimize costs and taxes can be complex and time-consuming.¹⁸, ¹⁹

Rebalancing vs. Asset Allocation

Asset allocation and rebalancing are closely related but distinct concepts in investment strategy. Asset allocation is the strategic decision of how an investor's total portfolio should be divided among different asset classes, such as equities, bonds, and cash. This decision is based on an individual's risk tolerance, investment goals, and time horizon. For example, an investor might decide on a 60% stock, 40% bond asset allocation.

Rebalancing, on the other hand, is the tactical process of maintaining that chosen asset allocation over time. As market values fluctuate, the initial proportions will inevitably drift. If stocks perform exceptionally well, their percentage of the portfolio will increase, making the portfolio riskier than initially intended. Rebalancing is the act of adjusting these proportions back to the original strategic asset allocation—selling some of the overweighted assets and buying more of the underweighted ones. Therefore, asset allocation sets the target, and rebalancing is the ongoing mechanism to hit and maintain that target.

¹⁷## FAQs

How often should I rebalance my portfolio?

The optimal frequency for rebalancing varies, but common approaches include time-based (e.g., annually, quarterly) or threshold-based (e.g., when an asset class deviates by 5% from its target). A¹³, ¹⁴, ¹⁵, ¹⁶nnual rebalancing is often cited as a practical balance between maintaining risk control and minimizing transaction costs and tax implications for many investors. T¹²he most important thing is to have a consistent plan and stick to it.

Does rebalancing always improve returns?

No, the primary goal of rebalancing is to manage risk and maintain a consistent risk tolerance, not necessarily to maximize returns. W⁹, ¹⁰, ¹¹hile it can lead to improved risk-adjusted returns by imposing a "buy low, sell high" discipline, it does not guarantee higher absolute returns, especially in continuously trending markets where a "buy and hold" strategy might temporarily outperform.

⁸### What happens if I don't rebalance?

If you don't rebalance, your portfolio's asset allocation will naturally drift over time due to varying asset class performance. This drift can lead to your portfolio becoming significantly riskier or more conservative than your initial risk tolerance and investment goals dictate. For example, in a long bull market, your portfolio might become heavily weighted towards equities, exposing you to greater losses during a downturn.

⁷### Can rebalancing be done automatically?

Yes, many modern investment platforms, including robo-advisors and certain managed mutual funds and Exchange-Traded Funds (ETFs) (especially target-date funds), offer automatic rebalancing services. T⁶his automates the process of adjusting your portfolio back to its target weights, helping you adhere to your investment strategy without manual intervention.

Are there tax-efficient ways to rebalance?

Yes. Rebalancing in tax-advantaged accounts like IRAs or 401(k)s can avoid immediate capital gains taxes. I², ³, ⁴, ⁵n taxable accounts, you can minimize taxes by directing new cash contributions to underweighted asset classes rather than selling appreciated assets. Additionally, utilizing tax-loss harvesting (selling assets at a loss to offset gains) can also be part of a tax-efficient rebalancing strategy.¹