Introduction The advice "buy low, sell high" is often seen as a straightforward investment...
Introduction
Rebalancing isn’t just a buzzword, it’s a proven strategy that helps long-term investors stay aligned with their financial goals. At its simplest, rebalancing means realigning the weight of different asset classes in your portfolio.
Markets don’t move in straight lines. Over time, a balanced 60/40 portfolio can drift into 70/30 during a rally or slip to 50/50 in a downturn. These shifts change your risk profile, often without you realizing it. Rebalancing brings your portfolio back to its intended allocation, ensuring your strategy, not market noise, drives your outcome.
Investors should prioritize long-term compounding, prudent risk management, and disciplined execution. Rebalancing reinforces all three. By keeping your portfolio aligned with its target mix, it allows compounding to work steadily without being disrupted by sudden swings in market sentiment. It also acts as a built-in risk control, preventing rallies or downturns from pushing your portfolio into risk levels you never intended.
Why It Matters: A Case of Portfolio Drift
As your portfolio grows, some assets inevitably outperform while others lag. This natural drift can create unintended risk. For example, if equities surge, they may take up a much larger share of your portfolio than planned, leaving you more exposed to market volatility. Conversely, if bonds outperform, your equity exposure shrinks, limiting growth potential and skewing you away from your intended risk–return balance.
The 2020 COVID-19 market crash offered a clear lesson. Investors who relied on disciplined rebalancing protocols, many through automatic systems, were better positioned for the recovery. By keeping portfolios aligned with long-term goals, rebalancing helped them avoid panic-selling and capture the rebound that followed (Wealthsimple).
Why Rebalancing Works: Premium and Risk Control
Imagine starting with a 60/40 stock–bond portfolio. As markets evolve, stocks surge and grow to 70% of your portfolio. Rebalancing means selling some of those equities and reallocating to bonds, restoring the 60/40 balance.
At the heart of this process are two key benefits:
- Capturing the Rebalancing Premium
By systematically selling assets that have risen and reallocating into those that have lagged, you’re effectively practicing a disciplined “buy low, sell high” strategy. This is what generates the rebalancing premium, the incremental return that can build up over time as markets cycle. Studies, including Morningstar’s research, have shown that in mean-reverting markets, this effect can boost long-term, risk-adjusted performance. - Maintaining Your Target Risk Profile
When markets move, your portfolio’s risk exposure shifts, often without you realizing it. A portfolio tilted heavily toward equities after a rally is more volatile than the one you originally planned for. Conversely, if bonds rally, your equity stake shrinks, reducing your growth potential. Rebalancing restores the balance, ensuring your portfolio stays aligned with your intended level of risk and return.
Together, these two forces, enhancing returns through the rebalancing premium and keeping risk on target, are what make rebalancing the cornerstone of a long-term investment discipline.
Types of Rebalancing Strategies
So how do investors actually put rebalancing into practice? There are three common approaches, each with its own strengths. The approach you choose should reflect your goals, risk tolerance, and investment style.
The graph below tracks the equity allocation of a U.S. 60/40 portfolio, consisting of the Russell 1000 Total Return Index for equities and the Bloomberg U.S. Aggregate Bond Index for bonds - starting with $10,000 invested in 2019. It compares two rebalancing strategies: annual and threshold-based. The shaded green area marks the acceptable equity allocation range for Threshold-Based rebalancing which is ±5 centered on the 60% equity target allocation (dotted line). The blue line reflects calendar-based rebalancing, which resets the equity weight to 60% at the start of each calendar year. The purple line shows the threshold-based strategy, which only rebalances when equity drift exceeds the 55–65% band. Allocation drift reflects market dynamics, such as the sharp equity drawdown in early 2020 and subsequent rallies.
While the Calendar-based strategy rebalances at fixed intervals (January of each year) , Over the 2019–2025 period, the threshold-based approach triggered only three rebalances, yet remained within the desired allocation band most of the time.
There is no right choice for rebalancing and the decision to choose a particular approach ultimately depends on an investor’s goals, preferences, and comfort with drift and trading frequency.
These methods illustrated above only outline the mechanics of different types of rebalancing strategies, but knowing when to apply them is just as important.
Timing Your Moves: When and How to Rebalance
There’s no single “perfect” time to rebalance, but there are a few situations and best practices that can help guide your decisions.
When to rebalance
- Regular check-ins and significant allocation drift – Reflecting calendar-based and threshold based rebalancing approach, this allows investors to keep portfolios aligned with their risk comfort level without overtrading.
- Life transitions – Major events such as retirement, receiving an inheritance, or preparing for a large expense may require revisiting your overall asset allocation. These shifts in circumstance often change your goals, time horizon, or risk tolerance.
How to Rebalance Wisely
- Use contributions and withdrawals strategically – One of the simplest ways to rebalance without incurring extra costs is to direct new contributions into underweight assets and fund withdrawals from overweight ones. For example, if equities have grown beyond their target allocation, you can put fresh contributions into bonds rather than buying more stocks. Similarly, if you need to withdraw cash, you can sell a portion of your overweight asset class instead of your underweight holdings. This approach helps restore balance gradually, while avoiding unnecessary trades that might trigger transaction fees or taxable events.
- Be mindful of taxes and fees – In taxable (non-registered) accounts, rebalancing can trigger capital gains. Factor this into your decision-making.
- Stay disciplined – The real purpose of rebalancing is to avoid emotional reactions to market swings. A rule-based approach ensures you act consistently, trimming winners and adding to laggards, rather than chasing momentum or panicking during downturns. This steadiness keeps your focus on long-term goals instead of short-term noise.
Potential Downsides and Hidden Costs
While rebalancing is widely promoted as best practice, it’s not without trade-offs. For both individual and institutional investors, the key is to understand these costs and manage them effectively.
- Trading Costs
Rebalancing requires buying and selling assets, which can trigger commissions, bid-ask spreads, and market impact. In less liquid markets, frequent trading or for large institutional trades, these costs add up. Over time, even small fractions can erode returns. - Tax Implications
In taxable (non-registered) accounts, rebalancing may realize capital gains. Selling equities after a strong rally, for example, creates a taxable event even if no cash is withdrawn. Without proper tax planning, this “tax drag” can meaningfully reduce long-term returns. - Front-Running and Market Impact
Institutional investors face a unique challenge: predictable rebalancing patterns can be anticipated by high-frequency traders. These firms may trade ahead of known rebalancing windows (such as end-of-quarter), nudging prices in ways that disadvantage slower-moving institutions.The CFA Institute estimates that predictable rebalancing has cost pension funds billions, with SSRN research suggesting annual losses of more than US$16 billion.
Rebalancing, then, is neither riskless nor costless. While it remains a cornerstone of disciplined portfolio management, investors, particularly large institutions and those in taxable environments, must carefully weigh frequency, timing, and methodology to ensure the benefits outweigh the costs.
Conclusion
Rebalancing is far more than a mechanical exercise, it’s a vital discipline for staying aligned with your long-term goals. Whether through calendar reminders, threshold rules, or automated platforms, the key is consistency. Making rebalancing part of your routine helps preserve your intended risk profile, capture the rebalancing premium, and ultimately enhance long-term outcomes.
