Rebalancing: why and how often

Rebalancing is frequently presented as a return-enhancing strategy, and its primary function is maintaining the risk level that was chosen.

What drift does

The mechanism.

Over time, the better-performing asset class grows as a proportion of the portfolio.

A portfolio set at sixty per cent equities and forty per cent bonds, left alone through a long equity bull market, becomes considerably more equity-heavy.

Which means the risk taken increases exactly as valuations rise, and the investor is most exposed at the point when a decline would hurt most.

Rebalancing restores the intended proportions, which is a risk control rather than a performance strategy.

The return question

Stated honestly.

Rebalancing sometimes improves returns and sometimes reduces them, depending on whether asset classes mean-revert or trend over the period.

In periods where one asset class outperforms persistently, rebalancing away from it reduces returns.

Studies of the rebalancing bonus find it small and inconsistent.

Which means the case for rebalancing rests on risk control rather than on return, and presenting it otherwise sets up disappointment.

Approaches

The main methods.

Calendar rebalancing: at a set interval — annually is common — regardless of drift.

Simple, predictable and may trade unnecessarily.

Threshold rebalancing: when an allocation drifts beyond a defined band, commonly expressed in percentage points or as a relative deviation.

Responds to actual drift and requires monitoring.

Combined: check at intervals and act only if beyond a threshold, which is what many practitioners use and which balances the two.

Research comparing methods generally finds the differences modest, which means the choice matters less than consistency.

Rebalancing with contributions

The preferable method while accumulating.

Directing new contributions to the underweight asset class restores the balance without selling anything.

Which avoids transaction costs and, in taxable accounts, avoids realising gains.

For investors making regular contributions relative to portfolio size, this can maintain the allocation entirely without any selling for years.

Similarly, directing withdrawals from the overweight asset class rebalances during drawdown.

The costs to consider

Which argue against rebalancing too frequently.

Transaction costs and spreads.

Tax on realised gains in taxable accounts, which can be substantial and which is the main reason to prefer contribution-based rebalancing.

Time and attention.

Which is why wide thresholds and infrequent checking are generally preferred over precise maintenance of the target.

A portfolio a few percentage points from target is not a problem; one substantially adrift is.

The psychological difficulty

Which is the real obstacle.

Rebalancing means selling what has done well and buying what has not, which is the opposite of what feels sensible.

During a market decline it means buying more of the falling asset, which requires either conviction or a rule.

Which is precisely why a written rule set in advance is more effective than a judgement made at the time.

The rule converts an uncomfortable decision into an administrative action.

When not to rebalance mechanically

Exceptions worth noting.

Where the target allocation should change because circumstances have changed — approaching a goal, a change in capacity for loss, a change in horizon.

Where a holding is being deliberately reduced over time for concentration reasons, such as employer shares.

Where tax consequences are substantial and can be managed by waiting for a new tax year or offsetting losses.

And in a glide path towards a target date, where the allocation is intended to change rather than remain constant.

The practical implementation

What to actually do.

Write down the target allocation and the rebalancing rule.

Check at a set interval — annually is sufficient for most people.

Rebalance with contributions first.

Sell only where contributions are insufficient and the drift exceeds the threshold.

Do it in tax-advantaged accounts in preference to taxable ones.

And record what you did and why, which makes the next occasion easier.

Multi-asset funds

The alternative.

Funds holding a fixed allocation across asset classes rebalance internally, which removes the decision entirely.

Target-date funds additionally adjust the allocation over time.

For investors who will not rebalance, or who would be tempted to interfere, these are frequently a better outcome than a self-managed portfolio despite slightly higher costs.

Which is a case where paying a little more for a structure that prevents behavioural error is rational.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.