What is rebalancing and why is it important? (2024)

FAQs

What is the purpose of rebalancing? ›

Rebalancing refers to making adjustments to your portfolio when your preferred asset allocation has shifted and is an important tool to keep you from straying too far from that asset mix.

In the end, rebalancing is a key practice for all investors. Knowing when to rebalance your portfolio can help ensure your money is working as hard as you are. Your investment strategy should reflect your goals, risk tolerance and time horizon.

Now, imagine that the market value of your stocks grows, but your bonds don't, and you end up with 70% of your portfolio value in stocks and only 30% in bonds. To rebalance, you would sell some of the stocks and buy more bonds—enough of both to bring the percentages back to 60/40.

In general, rebalancing your 401(k) doesn't cost you anything. You are selling your own assets and buying new ones, and most investment options included in your 401(k) do not incur a transaction fee. Trades that do incur fees are usually listed in an obvious manner.

The 5/25 rule for rebalancing indicates that you ought to adjust your portfolio if the proportion of any asset deviates from its intended initial allocation by an absolute margin of 5% or a relative one of 25%, opting for whichever threshold is lower.

Rebalance in tax-advantaged accounts

Because rebalancing can involve selling assets, it often results in a tax burden—but only if it's done within a taxable account. Selling these assets within a tax-advantaged account instead won't have any tax impact.

There is not a hard-and-fast rule on when to rebalance your portfolio. But many investors make it a habit to revisit their investment allocations annually, quarterly, or even monthly. Others decide to make changes when an asset allocation exceeds a certain threshold such as 5 percent.

Percentage-of-Portfolio Rebalancing

A preferred yet slightly more intensive approach to implement involves a rebalancing schedule focused on the allowable percentage composition of an asset in a portfolio. Every asset class, or individual security, is given a target weight and a corresponding tolerance range.

You should consider adopting a portfolio rebalancing strategy—even during down markets when it's tempting to let your “winners” keep growing while your “losers” are taking their lumps. That's because rebalancing helps you buy low and sell high—an investing adage that's easy to say and hard to do.

How Much Does It Cost to Rebalance a Portfolio? Most investment brokers don't charge commissions or trading fees for stocks and ETFs. So buying and selling stocks and funds is typically fee-free. If you own individual bonds, you're apt to pay a commission to buy or sell.

Is it better to rebalance quarterly or annually? ›

The bottom line. Our research shows that optimal rebalancing methods are neither too frequent, such as monthly or quarterly calendar-based methods, nor too infrequent, such as rebalancing only every two years. For many investors, implementing an annual rebalancing is optimal.

Rebalancing is an important way to help minimize volatility in a portfolio and may improve long-term returns.

Active rebalancing can also be expensive, as it involves trading fees and potential taxes. Each time an asset is bought or sold, investors must pay a trading fee or transaction costs. These fees can add up quickly, especially if an investor is frequently rebalancing their portfolio.

However, the rebalancing benefits are not always large. With this study, rebalancing between 1) US stocks and bonds, and 2) US and foreign stocks produced less than 10 basis points of extra annual returns. The reason for the fizzle was simple: Those assets behaved too similarly.

When? There are two general approaches to when you should rebalance your 401(k) account. One is to rebalance on a regular time schedule, such as quarterly, semiannually, or annually. This is the easier and more popular method.

The most common reason for changing your asset allocation is a change in your time horizon. In other words, as you get closer to your investment goal, you'll likely need to change your asset allocation.

How Often Should I Rebalance My Portfolio? Rebalancing too frequently can sacrifice returns. Rebalancing less often can bolster returns and increase portfolio volatility. Vanguard recommends checking your portfolio every six months, and rebalancing if the values drift 5% or more from target.

Rebalancing reliably reduces risk, but it doesn't necessarily improve returns.

You should consider adopting a portfolio rebalancing strategy—even during down markets when it's tempting to let your “winners” keep growing while your “losers” are taking their lumps. That's because rebalancing helps you buy low and sell high—an investing adage that's easy to say and hard to do.