When you build a portfolio, you usually choose a target mix of assets, such as a certain share in stocks, a certain share in bonds and some in cash. That mix reflects your goals, time horizon and tolerance for risk. Markets do not move in step, though, so over time the mix drifts. Rebalancing is the process of bringing the portfolio back toward its target. This article explains why drift happens and compares the two most common ways to rebalance.
Why portfolios drift
Suppose stocks rise strongly for a few years while bonds are flat. The stock portion grows into a larger share of the total than you planned, and the portfolio becomes riskier than the allocation you chose. The opposite can happen after a market decline, leaving you with less growth exposure than intended. Drift is not a mistake; it is simply what happens when different assets earn different returns. The question is how much drift you are willing to accept.
What rebalancing does
Rebalancing means selling some of what has grown beyond its target and buying more of what has fallen below it, or directing new contributions toward the underweight assets. The main purpose is risk control: keeping the portfolio aligned with the level of risk you decided was appropriate. Rebalancing is not designed to raise returns, and in a long rising market it can mean holding less of the best-performing asset than you would have without it.
Approach 1: Calendar-based rebalancing
With calendar rebalancing, you review and reset the portfolio on a fixed schedule, such as once or twice a year, regardless of what markets have done.
- Advantages: simple to remember, easy to automate, and it limits how often you look at the portfolio, which can reduce emotional decisions.
- Drawbacks: it ignores how far the portfolio has actually drifted. You may trade when drift is tiny, or wait months while drift becomes large after a sharp market move.
Approach 2: Threshold-based rebalancing
With threshold rebalancing, you set tolerance bands around each target weight. You rebalance only when an asset class moves outside its band.
- Advantages: trades happen only when drift is meaningful, so the portfolio stays closer to its intended risk without unnecessary activity.
- Drawbacks: it requires regular monitoring, and the choice of band width matters. Very narrow bands can trigger frequent trades; very wide bands allow the portfolio to stray a long way.
Combining the two
Many investors use a hybrid: they check the portfolio on a set schedule but only trade if an allocation is outside its band at that check. This keeps the routine of a calendar approach while avoiding trades that make little difference. Target-date funds and some managed accounts rebalance internally using their own rules, which is worth understanding if you hold them.
Costs and taxes to consider
Every trade can carry costs, such as commissions, bid-ask spreads or fund transaction fees. In taxable accounts, selling an investment that has gained in value may create a capital gains tax bill. Some ways to reduce the impact:
- Use new contributions or dividends to buy underweight assets instead of selling.
- Rebalance inside tax-advantaged accounts where trades generally do not trigger current taxes.
- Consider whether a small drift is worth a taxable sale at all.
Tax rules are detailed and depend on your situation, so check IRS guidance or a tax professional before selling in a taxable account.
Keeping it practical
- Write down your target allocation and the reason for it.
- Choose a method: calendar, threshold or a hybrid.
- Decide in advance how you will rebalance: new money first, then sales if needed.
- Review the target itself when your goals or time horizon change, not when markets are dramatic.
Key takeaways
- Rebalancing keeps a portfolio's risk close to the level you chose; it is not a return-boosting tactic.
- Calendar rebalancing is simple; threshold rebalancing responds to actual drift; a hybrid blends both.
- Trading costs and taxes matter, so use contributions and tax-advantaged accounts where possible.
- A written plan helps you rebalance consistently, especially when markets are volatile.
This article is general educational information, not investment, tax or legal advice, and it does not recommend any specific security or strategy. Check current details on Investor.gov (SEC) or FINRA, and consider speaking with a qualified, registered professional about your own situation.