Portfolio rebalancing

In simple terms

An asset allocation sets a target mix, for example 60% equity and 40% fixed income. Markets do not respect that mix. When shares rise faster than fixed income, equity grows to a larger share of the portfolio, and the portfolio becomes riskier than planned. When shares fall, the opposite happens.

Rebalancing brings the mix back to target: selling some of what has grown and buying what has shrunk.

How drift happens

Calendar and threshold rebalancing

Calendar rebalancing: check the portfolio at fixed intervals, such as once a year, and rebalance if needed. Simple and easy to remember.

Threshold rebalancing: rebalance only when an asset drifts beyond a band around its target, for example more than 5 percentage points. It avoids trading when drift is small and acts promptly after big moves.

Many investors combine them: check on a calendar, act only if the drift exceeds the band. Write the rule down in an investment policy statement, so the decision is not made in the heat of a rally or a crash.

Rebalancing with new money

Selling has costs: brokerage, exit loads and tax on gains, as the trading costs lesson explains. A cheaper way to rebalance is to direct cash flows:

• New contributions go to whichever asset is below target.
• Withdrawals come from whichever asset is above target.
• Dividends and interest are reinvested in the underweight asset.

For many savers, cash flows alone keep the mix close to target most of the time.

Taxes and costs

Rebalancing taxable holdings can trigger capital gains tax. The rules on holding periods and rates are set by law and change, so check them with the Income Tax Department before selling. Sometimes it is worth tolerating a little more drift, or rebalancing gradually, to avoid a large tax bill. Rebalancing within tax-advantaged accounts, where available, avoids this issue.

Why it feels hard

Rebalancing means selling what has done well and buying what has done badly, exactly when it feels least natural. After a rally, it feels like selling winners for no reason; after a crash, it feels like throwing money at losers. That discomfort is why a written rule helps, as the emotional decisions lesson explains.

Why it matters

Without rebalancing, a portfolio drifts towards whatever has risen most, and its risk rises, often just before a fall. Rebalancing keeps risk where you planned it, and imposes a discipline of trimming after strong runs and adding after weak ones.

Limitations

Rebalancing is mainly a risk-control tool; whether it raises returns depends on how markets behave, and in long trends it can reduce them. Costs and taxes are real trade-offs. The bands and intervals are judgements, not scientific constants.

Common mistakes

• Never rebalancing, letting risk drift up after rallies.
• Rebalancing too often, paying costs on small drifts.
• Ignoring tax when selling.
• Abandoning the rule when it feels uncomfortable.

Try it yourself

1. Write down a target allocation for one of your goals.
2. Find the current values of each part and calculate the actual mix.
3. Work out how much you would need to move to restore the target, first using planned contributions, then by selling if needed.
4. Write a rebalancing rule: how often you will check, and what drift will trigger action.