Rebalancing automatically forces the most disciplined investing principle: buy low, sell high. Without rebalancing, winning positions grow to dangerous levels. Rebalancing trims winners and adds to losers, maintaining target allocations. This disciplined approach improves long-term returns.
Time-Based vs. Threshold-Based
Time-based rebalancing (quarterly, semi-annually) is simple and reduces transaction costs. You know exactly when to rebalance. Threshold-based rebalancing (when allocations drift 5%) responds to market movements but triggers more frequently in volatile periods.
Optimal rebalancing frequency balances two costs: drift from target allocation and transaction costs. Too frequent rebalancing incurs excessive costs. Insufficient rebalancing allows dangerous drift. Most research suggests quarterly to semi-annual rebalancing is optimal for most portfolios.
Rebalancing Rules
Proportional rebalancing restores allocation percentages. Equal-weight rebalancing converts each holding to equal dollar amounts regardless of volatility. Volatility-weighted rebalancing adjusts allocations inversely to volatility. Different rules work better in different environments.
Threshold-based rebalancing triggers when allocations deviate from targets by a fixed percentage. A 5% threshold means rebalancing occurs when allocations drift 5 percentage points. This approach captures the benefits of buy low/sell high while minimizing transaction costs.
Tax Considerations
Rebalancing creates taxable events. In taxable accounts, rebalancing costs must be weighed against allocation drift. High-turnover rebalancing can create substantial tax drag. Tax-loss harvesting combined with rebalancing improves after-tax returns.
Tax-deferred accounts can rebalance freely without tax consequences. The reduced friction in tax-deferred accounts enables more frequent rebalancing and better discipline.
Rebalancing Edge
Rebalancing earns a "rebalancing premium" by systematically buying weakness and selling strength. This premium is smallest in trending markets (where rebalancing hurts) and largest in mean-reverting markets (where rebalancing helps). Regime-aware rebalancing adjusts frequency based on detected regimes.
Educational content only. Not investment advice.