Rebalancing: Keeping the Risk You Chose

Choosing a mix is a decision you make once. Keeping it is a decision you make every year, against your instincts, because markets move your portfolio away from the mix you chose without asking. Leave a portfolio alone through a long rise in stocks and it quietly becomes far riskier than you intended, usually just before that risk is tested. This chapter shows how fast drift happens, three ways to correct it, and how to do it without handing an avoidable share of your gains to taxes.

How a portfolio drifts

Different assets grow at different rates, so their shares of the portfolio change on their own. Take a 60/40 portfolio and let stocks earn 10% a year and bonds 3% a year for a decade, with no rebalancing.

The stocks grow from $60,000 to $155,625 and the bonds from $40,000 to $53,757. Stocks are now about 74% of the portfolio. The owner chose a balanced portfolio and now holds an aggressive one. If stocks then fell by the 60/40 mix's worst-year loss of the last century, 27.33%, the drifted portfolio would fall noticeably further than the one the owner signed up for.

Drift works in the other direction too. After a crash, stocks shrink as a share, and a portfolio that is never topped up becomes too cautious just when prices are lowest.

What rebalancing does and does not do

Rebalancing means selling some of what has grown beyond its target and buying what has fallen below it, or steering new money so the shares line up again.

Its main job is risk control: it keeps the portfolio's behaviour in a crash close to what you planned for. It also imposes a discipline most people find hard, trimming what has done well and adding to what has done badly.

Be wary of claims that rebalancing reliably raises returns. Over a long stretch in which stocks beat bonds, an untouched portfolio drifts toward stocks and often ends with more money than a rebalanced one, at the price of more risk along the way. Rebalancing between assets with similar long-run returns can add a little; between stocks and bonds, think of it as buying back the risk level you chose.

Three ways to rebalance

On a calendar. Check once a year, on a fixed date, and trade back to target. It is simple, easy to remember and fits neatly with year-end tax planning. Checking monthly or quarterly adds trades and costs without much benefit for most people.

When the drift passes a band. Rebalance only when an asset class is more than a set distance from its target. Common bands are 5 percentage points (a 60% stock target triggers at 55% or 65%) or 20 to 25% of the target itself (for a 60% target, about 12 to 15 points). Gobind Daryanani's 2008 study of rebalancing bands in the Journal of Financial Planning found that checking often but trading only when a fairly wide band was breached worked better than trading on a fixed schedule. The cost is that you have to look.

With cash flows. Send new contributions, dividends and interest to whatever is below target, and in retirement take withdrawals from whatever is above it. Nothing is sold, so nothing is taxed. It is slow to correct a large drift, but while you are adding money regularly it may be the only method you need.

Many investors combine them: steer cash flows all year, look at the mix each January, and trade only if it is outside the band.

Rebalancing without an avoidable tax bill

Selling in a taxable account can create a tax bill, so where and how you trade matters.

Trade inside tax-advantaged accounts first. Selling and buying inside a 401(k), IRA or Roth IRA triggers no tax. Since your allocation is measured across all your accounts, you can often restore the whole household mix by trading only in those accounts.

Hold for more than a year when you can. A gain on something held one year or less is short-term and taxed as ordinary income. Here is what a short-term gain of a few thousand dollars does to a single filer's federal tax.

A short-term gain that lifts income from $85,000 to $90,000 raises this filer's federal income tax from $9,870 to $10,970, because the gain is taxed at their top bracket of 22.0%. Had the same gain been long-term, it would have been taxed at 15%, since this filer's taxable income is above the top of the 0% band, $49,450 for a single filer in 2026 ($98,900 married filing jointly). Filers with lower taxable income can realise some long-term gains at 0%.

Sell the highest-cost lots. If you bought a fund at different times, you can usually tell your broker which shares to sell. Selling the shares you paid most for realises the smallest gain.

Use losses. If something in a taxable account is worth less than you paid, selling it realises a capital loss that offsets gains. Net losses beyond your gains can offset up to $3,000 of other income a year, and the rest carries forward (IRS Topic 409). To keep the loss, do not buy the same or a substantially identical investment within 30 days before or after the sale, the wash-sale rule, and remember the rule also looks at purchases in your IRAs.

The hard part is doing it

Rebalancing asks you to sell what everyone is excited about and buy what everyone is avoiding. After a long rise, it feels like giving up gains; after a crash, like throwing good money after bad. Recency bias, loss aversion and the fear of missing out all push against it.

Three things help. Write your target mix, band and review date down before you need them, so the decision is already made. Automate where you can: a target-date fund or a balanced fund rebalances itself, and many workplace plans and brokers offer automatic rebalancing. And judge the decision by whether you followed your rule, not by what markets did the next month.