Left alone, a portfolio drifts towards whatever has done best - which is the same as drifting towards a bet on the recent past continuing. Rebalancing is the small, unpleasant act that undoes it.
9 min read · Level 2
Rebalancing is often justified by claims that it improves returns, and that case is genuinely contested - over long periods and in strongly trending markets, never trimming the winner has frequently done better. The durable argument is about risk rather than return: without rebalancing, the amount you have at stake is decided by whatever recently went up, which means nobody is choosing it. The reason it is hard has nothing to do with the arithmetic, which takes two minutes. It is that the rule always instructs you to take money away from the holding you currently feel best about and hand it to the one you feel worst about, and every time it does so there will be an intelligent-sounding reason not to. Writing the rule down in advance is simply the acknowledgement that the version of you who meets that moment should not be the one deciding.
Rebalancing is selling some of what has grown beyond its target weight and buying what has fallen below it, so the portfolio returns to the allocation you chose. It can also be done without selling anything, by directing new contributions towards whatever is underweight - which is usually the cheaper route.
The need for it comes from arithmetic rather than from anything going wrong. Different assets grow at different rates, so the weights move even if you never touch anything. A portfolio set at 60/40 and left alone for years is no longer 60/40, and the longer it runs the further it has travelled from the plan.
Because drift is not neutral. A portfolio that has drifted is more heavily weighted towards whatever recently performed best, which means risk quietly rises after good periods and falls after bad ones - the opposite of what a plan intends, and the opposite of what most people would choose deliberately.
Rebalancing is also the only mechanical process most investors will ever have that requires selling something that is doing well and buying something that is not. That is unpleasant every single time, and the discomfort is the point: it is a rule that makes you act against the recent past without requiring you to predict the future.
This is educational information, not tax or accounting advice. Rules differ by country and change — get advice from a qualified professional in your jurisdiction before acting.
Educational, not personalised financial advice. Nothing in the Investor Academy is a recommendation to buy, sell or hold anything — what is right for you depends on your own circumstances and the rules where you live.
Sources: U.S. SEC — Investor.gov; U.S. IRS — official tax information; UK Government — Capital Gains Tax guidance
Continuing the previous lesson's portfolio: $100,000 at 60/40 becomes $90,000 after equities fall 20% and bonds rise 5%. The holdings are $48,000 of equities and $42,000 of bonds, which is 53.3% and 46.7%.
Restoring 60/40 on $90,000 means $54,000 of equities and $36,000 of bonds.
So the trade is to buy $6,000 of equities and sell $6,000 of bonds - $54,000 minus $48,000 in one direction, $42,000 minus $36,000 in the other.
Notice what this asks of you. Equities have just fallen 20%, the news is bad, and the rule says buy more of them using money from the thing that held up. That is why rebalancing tends to be written down as a rule in advance rather than decided in the moment, and why the portfolios that stay on plan are usually the ones whose owner removed the decision from themselves.
The main mistake is rebalancing on emotion - which in practice means never selling the winner and always finding a reason that this time the drift reflects something real.
The second is rebalancing too often. Frequent small adjustments cost money in trading and, where the account is taxable, can create tax events, while adding very little over a threshold-based approach. Precision here is bought at a price and does not repay it.
The third is ignoring where the trades happen. Selling an appreciated holding in a taxable account and selling the same holding inside a tax-advantaged one are not the same transaction, even though the portfolio ends up identical either way.
Either a calendar rule - review on a fixed date, annually is enough for most people - or a band rule, acting only when a weight moves beyond its agreed range. Either works; deciding in the moment does not.
A common approach is a fixed spread of a few percentage points, or a relative band such as a quarter either side of the target - for a 60% target, acting outside roughly 45% to 75%. Wide bands mean fewer trades and less cost, and they keep the rule from firing on ordinary noise.
Directing contributions, dividends and interest towards whatever is underweight moves the portfolio back towards target without selling anything. For anyone still adding money, this does much of the work at no cost.
Tax rules differ by country and by account type, and this Academy does not know your circumstances. As a general principle, in the United States selling an appreciated holding in a taxable brokerage account generally realises a capital gain while the same trade inside a tax-advantaged retirement account generally does not; in the United Kingdom a comparable distinction exists between a general investment account and an ISA. Both statements are simplifications - check your own position with someone qualified in your jurisdiction before acting on them.
If the rule fires and you decide to override it, write the reason down and date it. Overrides are sometimes correct, and a written record is what tells you later whether yours usually are.
On your chosen schedule, when a weight breaches its band, and whenever new money is being added - the last of these being the cheapest opportunity you get.
Do not rebalance reflexively after a sharp market move without checking the band and the costs first. Acting in the middle of turbulence is where trading costs are highest and where the temptation to quietly change the target rather than return to it is strongest.
A common outcome when a rebalancing rule fires after a long run in one asset class is that the target is revised rather than the portfolio. The reasoning offered is usually plausible and specific to the moment - the structure of the market has changed, the alternative asset no longer serves its purpose, the old target reflected different conditions. Sometimes that is right. But the revision reliably points in the direction of holding more of whatever has recently performed best, which is also what a plain unwillingness to sell the winner would produce, and from the outside the two are indistinguishable.
A target changed at the moment it becomes inconvenient carries almost no information. If you genuinely want to change it, change it at a calm review and record why.
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