Portfolio rebalancing brings your asset allocation back to target after market movements drift it away. Done correctly, it forces systematic buy-low-sell-high behavior. Done incorrectly, it creates unnecessary tax bills.
Why rebalancing matters
Starting at 70% stocks / 30% bonds. After a bull market, stocks become 85% of the portfolio. You now have more risk than planned — not through a decision, but through drift. A correction that should drop your portfolio 20% now drops it 30%. Rebalancing prevents risk from growing unchecked.
Two rebalancing approaches
| Method | How it works | Best for |
|---|---|---|
| Calendar rebalancing | Rebalance on a fixed schedule (annually or quarterly) | Simple, predictable, low trading frequency |
| Threshold rebalancing | Rebalance when any asset class drifts 5%+ from target | More precise, adapts to market volatility |
Tax-efficient rebalancing methods (in order of preference)
- Direct new contributions: Contribute new money to underweight asset classes. No selling, no taxes. Best method when you're still contributing.
- Rebalance inside tax-advantaged accounts: Sell and buy freely inside 401(k), IRA, HSA — no tax consequences. Save taxable account for last.
- Dividend reinvestment to underweight assets: Direct dividends to the underweight asset class instead of the source.
- Tax-loss harvesting combined: Sell overweight losers, use the loss to offset gains from selling other overweight positions.
- Sell in taxable account (last resort): Triggers capital gains. Hold 1+ year for long-term rates.
The evidence on rebalancing frequency
Vanguard research found that annual rebalancing provides essentially the same risk reduction as monthly rebalancing — with significantly lower transaction costs and tax drag. For most investors: rebalancing annually (or when drift exceeds 5%) is optimal.
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