Rebalancing

A portfolio set at 60% stocks and 40% bonds does not stay that way. When stocks rally, they grow to a larger share; when they fall, bonds take over. Over time, the portfolio's risk drifts away from what you chose. Rebalancing means trading back to the target weights, which usually involves selling what has risen and buying what has fallen. It keeps risk under control and enforces a disciplined, contrarian habit, but it costs trading fees and possibly taxes, so how and when to do it matters.

How drift happens#

Rebalancing methods#

Research by fund firms has generally found that rebalancing roughly annually, or when weights drift by around 5 percentage points, captures most of the risk control benefit without excessive trading.

The rebalancing premium#

When assets are volatile and not perfectly correlated, regularly rebalancing can add return compared with letting weights drift, because it systematically sells relatively high and buys relatively low. This effect, sometimes called a rebalancing bonus or diversification return, depends on assets mean reverting relative to each other. In strongly trending markets, rebalancing can reduce returns by trimming the winner too early. Its main, reliable benefit is risk control. See Mean Reversion and Trend Following.

Costs and taxes#

Rebalancing for traders and strategies#

The same logic applies to strategy allocations: a trading portfolio running several strategies drifts toward whichever performed best. Rebalancing risk allocations prevents one strategy from dominating. Volatility targeting is a related form: reducing exposure when volatility rises and increasing it when volatility falls. See Risk Budgeting and Risk Parity and Volatility and ATR-Based Sizing.

Index rebalancing#

Index funds rebalance when their index changes members or weights, which can create predictable trading flows around rebalancing dates. See Index Rebalancing.

Common mistakes#

1. Never rebalancing, letting risk drift for years.
2. Rebalancing too often, paying costs for little benefit.
3. Ignoring taxes in taxable accounts.
4. Abandoning the plan after a crash, when rebalancing means buying what has fallen. See Loss Aversion.
5. Forgetting all accounts: rebalance the whole household portfolio, not each account separately.

Frequently asked questions#

What is portfolio rebalancing?#

Trading a portfolio back to its target weights after market movements cause it to drift, typically by selling assets that have risen and buying those that have fallen.

How often should I rebalance?#

Many investors rebalance once a year or when an asset class drifts about 5 percentage points from its target, which balances risk control and cost.

Does rebalancing increase returns?#

Sometimes, when assets move back and forth relative to each other, but its main benefit is keeping risk at the intended level.

Next, learn how optimisation chooses weights in Portfolio Optimization.