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AAII How-To

When to Rebalance a Portfolio

While rebalancing can have advantages in terms of maintaining a desired allocation, rebalancing too frequently can result in undesired costs.

by Charles Rotblut | January 2022

Charles Rotblut leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

Rebalancing is the process of bringing a portfolio’s allocations back to their targets. Specifically, rebalancing involves selling a portion of overweighted investments and buying more of the underweighted investments. Rebalancing is typically done at the asset class (stocks, bonds, etc.) or asset class category (large-cap stocks, small-cap stocks, etc.) level.

While rebalancing can have advantages in terms of maintaining a desired allocation, rebalancing too frequently can result in undesired costs. In this article, we discuss why and when you should rebalance a portfolio.

Why Rebalance a Portfolio?

A portfolio’s allocation will shift over time based on the relative performance of each investment held. Historically, stocks have been the highest-performing asset class. This means that any portfolio comprising just stocks and bonds incurs a rising allocation to stocks over time if periodic rebalancing is not done.

A simple portfolio allocation of 50% large-company stocks and 50% long-term government bonds demonstrates this. Such a portfolio has experienced volatility of 11.1% (as measured by standard deviation) in its returns over the period from 1926 to 2020 when rebalanced annually back to its 50/50 allocation target, according to the 2021 SBBI Yearbook.

When the same portfolio was never rebalanced, its allocation shifted from 50% stocks/50% bonds in 1926 to 98.3% large-cap stocks and 1.7% long-term bonds at the end of 2020. This shift resulted in the never-rebalanced portfolio incurring 40% greater volatility than the portfolio that was rebalanced annually.

Our ongoing study of portfolio rebalancing finds that rebalancing preserves diversification and maintains risk reduction over shorter time frames as well. A periodically rebalanced portfolio following AAII’s moderate allocation model of 60% diversified stocks and 40% bonds over the period from 1988 through 2020 maintained the 60/40 allocation. This portfolio ended 2020 with an allocation of 63.6% in stocks and 36.4% in bonds. A non-rebalanced portfolio starting with the same allocation in 1988 ended 2020 with an 86% allocation to stocks and 14% allocation to bonds. The non-rebalanced portfolio’s drift caused it to experience 20% greater volatility than the rebalanced portfolio.

As you can see, periodic rebalancing preserves the diversification and risk reduction benefits of a given allocation. Not rebalancing causes these benefits to be diminished, or even be eliminated, over time.

Portfolio Rebalancing Is a Buy Low, Sell High Strategy

In addition to preserving an allocation, rebalancing prompts an investor to buy low and sell high. Dollars are shifted out of the best-performing assets and invested into the worst-performing assets.

This can be particularly beneficial during periods when optimism is too high or too low. If, say, stocks are in an extended bull market with high valuations, rebalancing prompts an investor to take profits. If stocks are experiencing a bear market, rebalancing prompts an investor to buy equities at depressed prices. The same applies to other asset classes included in a portfolio, be it bonds, publicly traded real estate, commodities or cryptocurrencies.

The Best Time to Rebalance

The frequency and timing at which a portfolio should be rebalanced depends on the level of simplicity you desire.

Annual rebalancing is the simplest approach. Each year, the portfolio’s asset class and asset class category allocations are adjusted back to their targets. Doing this at the start of each year attaches the task to an easy-to-remember date and makes use of year-end data.

Figure 1 shows a 60% stock/40% bond portfolio comprising five exchange-traded funds (ETFs). The portfolio was created on December 31, 2020, and is being tracked via AAII’s My Portfolio tool.

A quick glance shows that bonds—represented by the Vanguard Intermediate-Term Treasury Index ETF (VGIT)—is underweighted, with a portfolio weighting of 35.36% as of press time. Assuming the allocations did not change significantly at the end of 2021, an investor would have sold shares of the large-cap (S&P 500 index), mid-cap and small-cap ETFs and used the proceeds to purchase shares of the bond ETF on the first trading day of 2022. The dollar amounts would be the equivalent of what is required to bring the Vanguard Intermediate-Term Treasury Index ETF’s portfolio weight back up to 40%.

An alternative is to use a threshold-based approach. Rather than rebalancing on a specific date, rebalancing is only done when the allocation of one or more of the asset classes or asset class categories exceeds a certain threshold.

Bands of five or 10 percentage points are often used in such approaches. Under a 5% band threshold approach, the portfolio shown in Figure 1 would not be rebalanced because the bond weighting is within five percentage points of its 40% allocation target. The bond ETF’s portfolio weighting would have to fall below 35% (five percentage points below 40%) or rise above 45% (five percentage points above 40%) to prompt rebalancing. (Portfolio weightings below 10% or above 20% for any of the stock ETFs would also prompt rebalancing.)

The two approaches to rebalancing can be combined. An investor can check to see if any of their allocations exceed a certain threshold on a regular date, such as the beginning of a new year. If all allocations are within an acceptable range, no rebalancing is done. If any asset class or asset class category is above or below the predetermined thresholds, the portfolio is rebalanced on that date.

AAII members can use the portfolio weight in the right-hand column of the Portfolio tab of My Portfolio to see the current weights of their holdings. A+ Investor and AAII Platinum subscribers can use the Diversification Analyzer tab to see a percentage breakdown of their allocations by domestic stocks, foreign stocks, bonds, cash and other.

How to Rebalance a Portfolio

If rebalancing is needed, there are a few ways investors can go about it.

The first is to rebalance the portfolio on a single day. This involves selling a portion of the overweight assets and immediately investing the proceeds into the underweighted assets. It has the advantage of simplicity. It also works well when prices of the underweighted asset class or category are unusually low, such as during a bear market for stocks. This strategy can be the least tax-friendly, however.

A second strategy is to adjust future contributions. New dollars added to the portfolio are used to increase exposure to the underweighted asset classes or categories. This avoids capital gains taxes from being realized. For portfolios of significant size, new contributions may not be large enough to fully bring the portfolio’s overall allocation back to its target.

A third strategy is to use the portfolio’s cash proceeds to increase the allocation of the underweighted asset classes and categories. Dividends, distributions, interest income and the proceeds of large positions that are sold for reasons other than rebalancing (e.g., a stock meets the investor’s sell rules) all provide cash proceeds that can be used for rebalancing. As is the case with new contributions, the cash proceeds may not be large enough to rebalance the portfolio.

Retirees and other investors who are taking withdrawals can use a fourth strategy. Investments held in overweighted asset classes and categories are pared down first to free up cash to fund withdrawals. This strategy uses transactions that would have otherwise occurred to rebalance the portfolio. Again, size matters as the withdrawals may not be large enough to fully rebalance the portfolio.

Any of these strategies can be combined when rebalancing. An investor can combine regular savings contributions with cash proceeds from dividends and interest income to rebalance their portfolio over a certain period. A retiree can sell overweighted assets to satisfy the year’s required minimum withdrawal and complete any remaining rebalancing at once. The correct mix depends on the investor’s preferences and tax exposure.

If Allocation Matters to You, Then You Should Rebalance

The big benefit of rebalancing is preserving your target allocation strategy. If you have a portfolio allocation that you wish to follow, then you should incorporate plans to periodically rebalance your portfolio to maintain that allocation.

Discussion

ROBERT A from NC posted over 4 years ago:

"Dollars are shifted out of the best-performing assets and invested into the worst-performing assets." That says it all. Rebalancing: A guaranteed way to diminish your long-term returns.


RAINER F from MA posted over 4 years ago:

"Dollars are shifted out of the best-performing assets and invested into the worst-performing assets." That says it all. Rebalancing: A guaranteed way to diminish your long-term returns. Sarcasm or stupidity? There only are these 2 options.


RAINER F from MA posted over 4 years ago:

Rebalancing in taxable accounts can have adverse tax consequences, but taxable accounts are not the only account type and, as the author pointed out, there are ways of rebalancing (e.g. steering new contributions) without tax consequences. Over-all, rebalancing is a no-brainer, as the score-board clearly shows.


ROBERT A from NC posted over 4 years ago:

I wonder how often Warren Buffett rebalances his portfolio. What billionaire got that way through rebalancing? I cannot imagine pumping money into bonds in order to maintain a 40% portfolio weight -- or ANY arbitrary weight. What if I'd sold my LOW (bought in an UGMA for me in the 70s), my HD (which I bought in the 80s), or my MSFT (bought in the 90s) in order to rebalance? Wow, I could still be WORKING for a living! I'm SO glad I'm too stupid to accept the wonders of rebalancing. It's certainly a free country, and people are entitled to sandbag themselves if they choose. But the people who benefit most from rebalancing are those who make their living by encouraging others to do it.


ROBERT A from NC posted over 4 years ago:

AAII does a lot of good for the investing public, but this is my one gripe: There is too much regurgitation and repetition of conventional “wisdom.” Volatility=risk, rebalancing is a good thing, let your emotions dictate asset allocation, etc. I would much rather see such concepts honestly debated than to constantly read the same old mantra. Surely there must be some pointy-headed academics or other authors out there who take issue with such tripe. AAII members would be better served by the presentation of alternative, unorthodox views on investing – or at least open debates about “widely accepted” ideas.


ROBERT A from NC posted over 4 years ago:

Evidence against rebalancing: Take a look at the relative long-term performance of IVV and RSP. Both are index ETFs based on the S&P 500. RSP, being an equal-weighted ETF, rebalances regularly while IVV, which is cap-weighted, generally does not significantly rebalance. IVV's 10-year, 5-year, and 3-year performance is superior to that of RSP. The difference between QQQ and QQEW is even more striking (both follow the NASDAQ 100). Maybe this is merely anecdotal and can be explained by other factors, but from where I'm sitting, it certainly does not support rebalancing as a means to improve long-term portfolio performance.


Steven P from OR posted over 4 years ago:

I do not like the assumption that volatility = bad risk. This is not always true. What I would like to see as a part of this article, in the introductory "Why Balance the Portfolio" section is a chart showing the end of year portfolio value for the balanced vs. unbalanced in the numerical examples cited. AAII's own authors have stated that risk has to do with the risk that you will need to withdraw funds when the volatility has the portfolio value down. This is a much better definition than the simplistic all volatility is bad risk assumption implicit in this article.


Wayne S from MA posted over 4 years ago:

I would prefer to see a rebalancing conversation as it relates to economic cycles. Shifts in sectors and industries. Where to be over or underweight. As the economy moves through its growth and retraction cycles there are so many opinions as to when these shifts occurs. Should you be a month or two ahead of where you think that cycle changes? Because when the market does shift, it happens like an earthquake vs. a slow erosion.


MARGARET G from MO posted over 4 years ago:

I agree with Robert, Rainer, Steven and the author of the article. I'm sure you are scratching your head already. In my opinion you should always go with the hot hand and take one or two time limited profits in your high flyers off the table and let the rest run. Robert, based upon the time period you acquired LOW, HD and MSFT you would be kicking yourself had you annually sold shares in those companies to rebalance. But, let's not forget that investors have differing risk tolerances. There would have been many who would have been kicking themselves for not rebalancing in 2008/2009 when stock prices went down 30%+ and Bond prices increased 25%+. In my opinion the "conventional wisdom" of rebalancing may be appropriate for those that are risk averse or with a conservative investment strategy. With all of this said, it may be more appropriate if the article was prefaced with "Portfolio Rebalancing is a sound strategy for a conservative investor and those who are risk averse".


Lance Y from NV posted over 4 years ago:

In my opinion - formed based on some data analysis - 'regular time-based' rebalancing does not improve overall investment returns (though it does in many cases reduce volatility). It's important to note that the author does not make the claim that rebalancing is better for returns. In regards to the comments arguing what's better for returns, I agree never rebalancing and/or a 100% stock portfolio is the way to go (over the long-term) based on historical market performance. However, almost every investor seeks a balance between risk and return based on their time frame and their circumstances thus their specific target/starting allocation. I believe the author was trying to make the point that if your starting allocation is still appropriate for your circumstances, then you should consider rebalancing as time goes on. Btw, I note the article's examples use stock vs. bond class allocations however the allocation/rebalancing concept is equally applicable to sectors, styles, types, and geography. Importantly, the article provides some practical ideas for rebalancing (when adding or withdrawing from a portfolio for example) though a deeper discussion on the benefits of rebalancing within tax protected accounts and perhaps how to better sequence rebalance options based on life stage would be helpful too. To me, the critical point in rebalancing is to do it when I'm essentially "buying low and selling high". There is no specific time period or threshold that makes achieving better returns through rebalancing easy (though arguably thresholds are perhaps somewhat more helpful) rather good judgment, clarity on your investment objectives, and the willingness to remain open to new information and to act accordingly is how to make rebalancing work best for you.


ADAM G from MA posted over 4 years ago:

I would like to see a discussion of use of technical indicators to guide timing of re-balancing decisions. While it is usually good advice to not try to time the market, using TA may avoid selling assets that are still rising or buying those that are still declining.


ROBERT A from NC posted over 4 years ago:

I suppose if someone sleeps better at night with bonds in their portfolio, I should not try to dissuade them. But they should recognize that warm and fuzzy feelings have a cost. It's a real cost that is paid over time in the form of reduced returns. I think it is better to toughen up and adapt yourself to reality than to let your emotions drive your investment decisions. And investing in underperforming assets to satisfy your "risk tolerance" is doing just that -- letting your emotions instead of your intellect drive your investment decisions. Margaret, I don't ever kick myself as a result of a market crash (and I've lived -- and stayed the course with my stocks -- through several of them). The market always comes back and charges ahead. If ever it doesn't, then all of us are in trouble no matter what assets we own.


Lance Y from NV posted over 4 years ago:

Robert, it's not about warm and fuzzy feelings. Volatility is a consideration for many investors, especially those who withdraw regularly. If an investor is in their accumulation phase (working full time, saving/investing since their employment cash flows exceed their living expenses) and has many years ahead of them to keep adding to their investments - then most everyone agrees having more, a lot, or even all stocks is better for financial returns in the mid- and longer-term. However, if one withdraws from their investments regularly (like most retirees do) then they don't have the same time flexibility (some might say luxury) to wait for the market to bounce back. Also, those about to enter retirement usually increase their bond holdings due to the risk of 'sequence of returns'. Lastly, even for working/accumulating investors - bonds can provide the means to add even more stocks to your portfolio (through rebalancing) beyond your savings/investments from other sources. Separate to the above comment - after reading this article, I subsequently found an older article online about "Opportunistic Rebalancing" written by Gobind Daryanani (CFP, Ph.D). A bit of a long read and some technical details but the key ideas are helpful and maybe useful to those who have a portfolio beyond stocks only.


JOHN H from TN posted over 4 years ago:

Based on a sentence in another article ("The Benefits and Risks of Small-Cap Funds") that the VB market cap goes up to $6B, I wondered if the 15% allocation to each of the US ETFs in Figure 1 came close to the 15% of each capitalization category. Using Morningstar's portfolio capitalization breakdown for each fund, multiplying each percentage by 15%, and adding the results for each category, I found that Large Caps were 15% of the portfolio, while Mid Caps were about 20% of the portfolio, and Small caps about 9% of the portfolio. That skew towards Mid Cap and away from Small Cap is interesting, and it shows how difficult it is to get a "pure" balance based on market capitalization.


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