THE IMPORTANCE OF
REBALANCING YOUR PORTFOLIO

When market movements cause changes to the value of your individual holdings your portfolio might no longer be set up as you originally intended. This article helps explain what portfolio drift is and ways to rebalance your portfolio to stay on course to meet your investment aims.

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Portfolio rebalancing involves adjusting your investment holdings to maintain your intended asset mix. It’s a way to adjust your portfolio to adapt to market events and remain inline with your original investment strategy and risk tolerance.

If market price moves have resulted in your portfolio no longer matching your initial strategy, you may want to rebalance it. This is how.

What Is Portfolio Rebalancing?

Portfolio rebalancing in its purest form is the process of buying and selling assets to restore a portfolio’s original or target asset allocation. It is done to try to ensure your portfolio is set up to match your investment aims.

Over time, market movements cause the value of the individual holdings in your portfolio to change. If one asset class increases in value and another falls, your overall portfolio may no longer align with your risk tolerance or investment objectives.

This unintentional deviation from your intended course of action is called “portfolio drift”, which can be explained using a case study.

Case Study: Portfolio drift adding risk:

• Diane is nearing retirement age and targets a relatively low risk portfolio holding 60% bonds and 40% stocks. 
• Following a bull market the actual breakdown of the portfolio shifts to 35% bonds and 75% stocks. 
• The portfolio’s risk characteristics have changed to be higher risk because stock prices are typically more volatile than bond prices.

Case Study: Portfolio drift limiting opportunities:

• 24-year old Julian has a long investment time horizon and targets holding 90% stocks and 10% bonds. 
• Following a bear market the actual breakdown of the portfolio shifts to 65% stocks and 35% bonds. 
• The portfolio’s risk profile is now lower than initially intended.

How Does Portfolio Rebalancing Work?

Portfolio rebalancing works by measuring current allocations against target allocations and making adjustments when meaningful drift occurs. The process involves calculating position values, identifying deviations, and executing trades to restore balance.

Establishing whether your portfolio requires rebalancing involves measuring the value, risk-profile, and comparative performance of the assets within it. 

Continuing our case studies outlines the typical steps taken to rebalance a portfolio.

Case Study – Portfolio drift adding risk:

• Rebalancing Diane’s portfolio would involve selling and reducing some stock positions and purchasing bonds to restore the 60/40 target.

Case Study – Portfolio drift limiting opportunities:

• Julian’s portfolio has inadvertently developed a lower risk profile than he desires. To rebalance he would sell some bond assets and buy stocks, until the 90/10 split is restored.

What is portfolio breakdown analysis

Rebalancing starts with portfolio breakdown analysis which establishes how investments are distributed by asset type, sector, geographical region, and exchange. That data helps investors pursue an approach where they allocate capital to meet long-term goals.

The table below outlines the factors to consider when performing breakdown analysis.

Measure	What it describes	What it can indicate (neutral)
Allocation breakdown	Percentage of portfolio in each asset class	How far current mix has drifted from targets
Risk contribution	How much each position contributes to overall risk score based on price volatility	Whether portfolio risk has shifted unintentionally
Benchmark comparison	Performance relative to relevant market indices	How portfolio positioning affects relative returns
Income contribution	Dividend and interest payments by asset	Changes in portfolio’s income-generating capacity

How To Rebalance Your Investment Portfolio

Rebalancing your investment portfolio involves measuring drift and taking action to bring your portfolio back in line with your investment aims. There are other factors such as trading costs  and tax considerations to also consider which adds more nuance to the process.

The sequence many investors follow includes:

1. Define target asset mix based on investment objectives
2. Measure current portfolio allocations
3. Identify meaningful drift from targets
4. Consider transaction costs, tax implications, and market conditions
5. Execute adjustments through selling overweight positions and buying underweight ones
6. Or, if you are adopting a recurring investing strategy, allocate each future installment to the underweight sector until target allocation is restored.
7. Document changes and schedule next review

Various analytical tools can help investors assess their portfolios. These may include portfolio analysis software, risk measurement tools, and performance attribution systems that help identify how allocations have shifted.

Fitting all of these variables into your decision making involves understanding which particular events will act as a sign to initiate rebalancing.

Calendar-based rebalancing

Calendar-based rebalancing involves reviewing and adjusting portfolios at predetermined time intervals. Investors using this approach might rebalance quarterly, semi-annually, or annually regardless of market movements.

This systematic approach:

• Reduces the emotional element from the rebalancing decision. 
• Provides a reasonable balance between maintaining target allocations and minimising transaction costs.
• Allows for effective planning of the time and resources needed to perform rebalancing.
• Can result in adjustment of portfolios when drift is minimal, incurring unnecessary costs.

Trigger-based rebalancing

Trigger-based rebalancing occurs when asset allocations drift beyond predetermined threshold percentages. An investor might for example set a 5% or 10% threshold, rebalancing whenever any asset class deviates by that amount from its target.

This reactive approach:

• Responds directly to market movements rather than calendar dates. 
• Can be more responsive to market conditions than calendar-based methods.
• Can keep portfolios more in line with investment objectives as remedial action is taken sooner.
• May result in more frequent trading during volatile periods, potentially increasing costs.

In practice, it can make sense to adopt an approach which combines both the calendar and trigger based methods of rebalancing.

Combination approach

A combination approach uses both time-based reviews and drift triggers to determine when rebalancing occurs. This ensures portfolios benefit from both regular adjustments and ad hoc rebalancing should it be needed.

For example, an investor might conduct annual reviews while also monitoring for 10% drift thresholds. This dual approach provides systematic oversight while remaining responsive to significant market movements.

The respective strengths and weaknesses of the different approaches are outlined in the table below.

Approach	What it means	Common trade-off (neutral)
Calendar-based	Review at fixed time intervals (quarterly, annually)	May allow significant drift between reviews
Trigger-based	Rebalance when allocations exceed threshold percentages	Can increase trading frequency and costs during volatility
Combination	Use both calendar reviews and drift triggers	Requires more active monitoring but provides flexibility

Main Reasons Investors Consider Rebalancing

The main reason investors consider rebalancing is to maintain alignment with their intended investment strategy and risk parameters. There are additional motivational factors to consider which can enhance your investment approach.

Rebalancing encourages you to:

• Monitor two crucial factors, risk, and performance.
• Keep your long-term aims in mind.
• Consider the likelihood and impact of an increase in market volatility.
• Assess how a market shock could trigger a substantial fall in the overall value of your portfolio.
• Maintain investment discipline by systematically selling assets that have appreciated and buying those that have underperformed.
• Balance capital growth and income considerations. Investors focused on income might rebalance to restore their preferred mix of income-producing assets.

Time horizon adjustments

Changes in investment time horizons often prompt portfolio rebalancing considerations. As investors approach specific goals or life stages, their capacity for risk and need for liquidity typically evolve.

Rotating into lower-volatility assets when your plan is nearing maturity can help you to still meet your investment aims even if there is a short-term shock. Some investors reassess their risk tolerance and liquidity needs as time horizons shorten, though specific adjustments vary by individual circumstances.

How Often Should You Rebalance a Portfolio?

Portfolio rebalancing frequency depends on individual circumstances, market conditions, and cost considerations. No universal schedule suits all investors, as factors including volatility, complexity, and transaction costs influence optimal timing.

Under normal conditions it might be appropriate to rebalance your portfolio once or twice a year, but during periods of market uncertainty or if your portfolio holds more volatile assets you may decide to make more regular adjustments. 

Whatever the timeframe, when carrying out a rebalancing review establish::

• If it would be prudent to adjust the frequency
• Whether your personal circumstances and overall investment aims have changed.
• Have changes to transaction costs influenced the cost-benefit of rebalancing.
• Your tolerance for portfolio drift.
• Whether market volatility levels have changed, or might be expected to change in the future.
• If tax codes have changed or are due to change.

Final thoughts 

Portfolio rebalancing offers a systematic approach to maintaining intended investment allocations, though it does not eliminate investment risks or guarantee returns. 

Breaking the process down into two elements can help investors get the most benefit. Regular monitoring can improve reaction times and actively considering the returns and risk of your portfolio is always a good idea.

The second part of the process, actually executing trades, could then be done when the benefits clearly outweigh the costs, considering both financial expenses and tax implications.

Different approaches suit different investors. The key lies in selecting an approach that aligns with individual circumstances and consistently applying it over time.

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FAQs

Does portfolio rebalancing guarantee better returns?

No, portfolio rebalancing does not guarantee improved returns. Rebalancing is primarily about maintaining your intended risk level and investment strategy alignment. In some market conditions, rebalancing might actually reduce returns, particularly in strong trending markets. The process involves selling assets that have performed well to buy those that have underperformed, which may work against you if trends continue.

What costs should investors consider when rebalancing?

Rebalancing costs include transaction fees, bid-ask spreads, and potential tax implications from selling positions that have gained value. Transaction fees vary by broker and asset type. Spreads represent the difference between buying and selling prices. 

Tax considerations depend on jurisdiction and account type, with capital gains taxes potentially applying to profitable sales in taxable accounts.

How is rebalancing different from diversification?

Diversification involves spreading investments across different assets to manage risk, while rebalancing maintains your chosen diversification levels over time. Diversification is the initial portfolio construction strategy. Rebalancing is the ongoing maintenance process that preserves your diversification targets as markets move.

Can you rebalance using new contributions instead of selling?

Yes, investors can rebalance by directing new contributions toward underweight asset classes rather than selling overweight positions. This approach, sometimes called “rebalancing through contributions,” avoids transaction costs and tax implications of selling. It works particularly well for investors following a dollar-cost-averaging approach, though it may take longer to restore target allocations compared to selling and buying.

Should rebalancing strategies change during market crashes?

Market crashes present unique considerations for rebalancing. Some investors build tolerance into their strategies which allows them to rotate into and out of riskier assets when there are changes in market sentiment.

Others with a longer term investment time horizon may take a buy and hold approach and ride out the natural fluctuations of the market. The decision depends on individual investment aims, risk tolerance, and overall strategy rather than following universal rules.