Rebalancing is the process of restoring your portfolio to its target allocation after market movements have caused it to drift. If your target is 80% stocks / 20% bonds and stocks outperform, you might end up at 87% / 13%. Rebalancing means selling some stocks and buying bonds to return to 80/20.

Why Rebalance?

Rebalancing manages risk, not returns. A portfolio that started at 80% stocks and drifted to 90% stocks after a bull market is now taking more risk than you intended — it will fall further in a correction. Rebalancing restores the risk level you originally chose. It also mechanically enforces buy-low / sell-high behaviour: you sell assets that have risen (stocks after a bull run) and buy assets that have fallen (bonds).

Important: Research shows that rebalancing does not reliably improve long-term returns — it maintains risk. Don't rebalance hoping for higher returns; rebalance to keep your risk exposure where you want it.

How Often to Rebalance: The Evidence

Studies from Vanguard and Morningstar show that annual or threshold-based rebalancing produces similar outcomes. Over-frequent rebalancing (monthly) generates unnecessary transaction costs and, in taxable accounts, taxable events. The optimal strategy is one of:

  • Annual rebalancing: Pick a date (January, your birthday) and rebalance regardless of drift
  • Threshold rebalancing: Rebalance when any asset class drifts more than 5% from its target (80% stocks becomes 85% or 75%)
  • Hybrid: Check annually; rebalance only if drift exceeds 5%

The Tax-Smart Way to Rebalance

In tax-advantaged accounts (401k, IRA): rebalance freely — there are no tax consequences for selling and buying within these accounts.

In taxable brokerage accounts: prefer rebalancing by directing new contributions toward underweight asset classes rather than selling overweight ones. This avoids triggering capital gains. If you must sell, prioritise assets held more than one year (long-term capital gains rate) over those held less than a year (ordinary income rate).

Rebalancing with New Contributions

The easiest rebalancing approach for investors still contributing: direct each new contribution to whichever asset class is below target. If stocks are at 88% (target 80%), put new money into bonds until you're back to 80/20. This requires no selling and no tax consequences.