Why Rebalancing Is Necessary and the Risks of Neglecting It
Even if your portfolio matches the target allocation at the time of construction, the allocation drifts over time due to differences in returns across assets. For example, if you start with a target allocation of 60% equities and 40% bonds, and after a year of strong equity markets the allocation shifts to 70% equities and 30% bonds, leaving this uncorrected means you are taking higher risk than originally intended, potentially suffering greater-than-expected losses in the next market downturn. Rebalancing is the process of restoring the drifted allocation back to the target.
Rebalancing also has a "contrarian" effect. By selling assets that have risen in value and purchasing those that have declined, it mechanically executes the fundamental investment principle of "selling high and buying low." Vanguard's research shows that rebalanced portfolios tend to have improved risk-adjusted returns compared to portfolios left unattended. However, rebalancing too frequently increases transaction costs and taxes, so setting the appropriate frequency and rules is important.
Two Rebalancing Methods: Time-Based and Threshold-Based
Rebalancing methods fall broadly into two categories. Time-based rebalancing reviews the portfolio at predetermined intervals (monthly, quarterly, semi-annually, or annually). It is simple to implement - just set a calendar reminder. Research shows that annual rebalancing provides sufficient benefit, and increasing the frequency yields only marginal improvement in risk-adjusted returns.Books on optimizing rebalancing frequency also provide detailed performance comparisons across different frequencies.
Threshold-based rebalancing triggers execution only when the asset allocation deviates from the target by a certain band (for example, 5%). If the target equity allocation is 60% with a 5% threshold, rebalancing is executed when the equity ratio exceeds 65% or falls below 55%. This method can respond quickly to large market movements, but requires continuous monitoring of the allocation. In practice, a hybrid approach combining both methods - "annual scheduled check plus ad-hoc rebalancing when deviation exceeds 10%" - is efficient.
Concrete Methods for Automating Rebalancing
The easiest way to automate rebalancing is to use balanced funds or target-date funds. These funds automatically rebalance internally, requiring no action from the investor. However, their management fees tend to be higher than combining individual funds. If you build your own portfolio, cash flow rebalancing - adjusting where new funds are directed - is the most tax-efficient method. With monthly systematic investments, direct funds disproportionately toward the asset class that is below its target allocation.
Some brokerages offer services that allow you to specify allocation ratios for automatic mutual fund investments.Practical books on automatic investment and portfolio setup explain that by setting investment ratios across multiple funds and periodically reviewing the ratios, you can achieve efficient rebalancing without selling. Once a year, adjust the investment ratios based on the difference between the current and target allocations, and over time the allocation will converge toward the target.
Next Actions for Starting Rebalancing Today
To introduce a rebalancing system, the first step is to clearly define your portfolio's target allocation in numerical terms. Write out the target ratio for each asset class on paper or in a spreadsheet, such as "60% equities, 30% bonds, 10% cash." Next, calculate your current actual allocation and check the deviation from the target. If any asset class has a deviation of 5% or more, direct your next systematic investment toward reducing that deviation.
The easiest automation method is cash flow rebalancing by adjusting the allocation ratios of your monthly systematic investments. Set a reminder on your smartphone calendar for "January each year: portfolio allocation check" and make the annual review a habit. We recommend using our compound interest calculator to compare long-term returns with and without rebalancing, and quantitatively confirm the risk management benefits.