Portfolio Rebalancing: When and How to Do It
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Rebalancing is one of the few proven ways to improve returns while reducing risk. This guide explains when and how to rebalance your portfolio.
Rebalancing is the practice of periodically restoring your portfolio to its target asset allocation by selling what has grown and buying what has lagged. Its purpose is not to boost returns — it is to prevent your risk level from drifting upward in a bull market without a conscious decision. The two standard approaches are calendar-based (annually) and threshold-based (when any position drifts more than about five percentage points from target).
Why portfolios drift, and why that is a problem
You set a 70/30 stock/bond allocation. Stocks then outperform for three years running. Without any action, the portfolio becomes 78/22, then 84/16. Each year your expected return rises slightly and your worst-case drawdown deepens — but you never chose that. The drift is a silent increase in risk that always happens at the worst time, because it is driven by the same bull market that makes investors feel most confident.
Rebalancing is the corrective. By trimming equities after strong performance and adding to bonds, you lock in some gains and restore the risk profile you actually chose. The secondary benefit is behavioural: it creates a rule that forces you to buy the thing that has been performing badly, which is usually the hardest and most rewarding action to take.
Calendar vs threshold, and the tax problem
Calendar rebalancing is simplest: check once a year on a fixed date and adjust back to target. Threshold rebalancing acts whenever an allocation drifts more than a set amount, commonly 5 percentage points. Research generally finds that threshold-based rebalancing at around 5 percentage points captures most of the risk-control benefit while trading less often than a tight threshold would.
The complication is tax. In a tax-advantaged account rebalancing is free of tax consequences, so it can be done whenever needed. In a taxable account, selling to rebalance realises capital gains. The solution is to rebalance with the tools that do not trigger tax: direct new contributions to the underweight asset, reinvest dividends into the underweight asset, or — if you hold assets in both account types — do the selling inside the tax-advantaged account while holding the position steady in the taxable one.
This last technique is called asset location: holding your highest-growth assets (equities) in tax-advantaged accounts and your lower-growth, income-producing assets in taxable accounts where the tax treatment is gentler. It reduces tax drag, but it can make rebalancing the whole portfolio more complex, so it is worth doing only once the portfolio is large enough to justify the tracking.
Worked example: rebalancing a $200,000 portfolio
Target: 60% U.S. equity ($120,000), 25% international ($50,000), 15% bonds ($30,000).
After one strong year: U.S. equity returns 24%, international returns 9%, bonds return 2%. New values: U.S. $148,800, international $54,500, bonds $30,600. Total $233,900. The new split is 63.6% / 23.3% / 13.1%.
Target values at $233,900 are 60% = $140,340, 25% = $58,475, 15% = $35,085. The U.S. position is $8,460 overweight and bonds are $4,485 underweight. Neither breach the 5-point threshold, so a strict threshold rule would say do nothing.
If you do rebalance: sell $8,460 of U.S. equity and add $3,975 to international and $4,485 to bonds. In a taxable account that sale might trigger about $1,700 of capital gains and roughly $255 in tax at 15%. Which is why the efficient version is to direct the next $8,460 of new contributions to bonds and international instead, rebalancing without selling anything.
Rebalancing methods compared
| Method | Trigger | Trades | Tax cost | Best for |
|---|---|---|---|---|
| Calendar (annual) | Fixed date | Low | Low | Simplicity, most investors |
| Threshold 5% | 5-point drift | Moderate | Moderate | Tighter risk control |
| Threshold 10% | 10-point drift | Low | Low | Taxable accounts |
| Contribution-based | New contributions | None (no selling) | None | Taxable accounts, accumulation phase |
| Full sell-and-buy | Any drift | High | High | Tax-advantaged accounts only |
Risks and Points of Caution
- Rebalancing by selling in a taxable account triggers capital gains that reduce the net benefit.
- Rebalancing too frequently increases costs and taxes without improving risk control.
- Waiting until a very large drift means accepting materially higher risk than intended in the interim.
- Selling equities to rebalance near a market bottom locks in losses — use contributions instead if possible.
- Rebalancing across accounts without accounting for asset location can create an unintended overall allocation.
What to do next
Write the rule down before you need it.
- Specify your target allocation as percentages, in writing.
- Choose a rebalancing rule: annual, or a 5-point drift threshold.
- In taxable accounts, rebalance using new contributions and dividends rather than sales.
- Do the actual selling inside tax-advantaged accounts where possible.
- Check the overall allocation across all accounts, not just one account at a time.
- Do not rebalance more than once a quarter; more frequent action adds cost without benefit.
Sources and Further Reading
- Asset Allocation and DiversificationU.S. Securities and Exchange Commission
- Rebalancing Your PortfolioU.S. Securities and Exchange Commission
- Publication 550: Investment Income and ExpensesInternal Revenue Service
Sources were consulted when this guide was last reviewed. Where a figure is a range, it reflects the spread across the sources listed rather than a single quoted number. See our source policy and fact-checking process.
Key Takeaways
- Rebalancing restores your chosen risk level, which drifts upward in bull markets without intervention.
- Annual or 5-point-threshold rebalancing captures most of the benefit at low cost.
- In taxable accounts, rebalance with new contributions instead of selling to avoid capital gains.
- Rebalancing also enforces a disciplined form of selling high and buying low.
Frequently Asked Questions
Does rebalancing improve returns?
Not reliably — its main benefit is risk control, keeping your allocation at the level you chose. Any return enhancement is marginal and depends on the market path. The benefit to risk is consistent and real.
How often should I rebalance?
Annually, or when an allocation drifts more than about 5 percentage points from target. More frequent rebalancing adds transaction costs and taxes without meaningfully improving risk control.
Can I rebalance without selling?
Yes — direct new contributions and reinvested dividends to the underweight asset. This is the preferred method in taxable accounts because it triggers no capital gains.