How Rebalancing Works and Why Investors Should Do It Annually
Building a diversified investment portfolio is only the first step toward long-term financial success. Maintaining that portfolio — especially by keeping your asset allocation aligned with your goals — is where many investors fall short. That’s where rebalancing comes in.
Rebalancing is one of the most powerful, yet underutilized, tools in long-term portfolio management. It keeps your risk exposure consistent and helps you avoid the classic mistake of letting winners run too long — or worse, letting market volatility steer your strategy.
In this article, we’ll break down how rebalancing works, why doing it annually can be a smart move, and how it fits into a disciplined investment strategy.
What Is Portfolio Rebalancing?
Rebalancing is the process of adjusting your portfolio to bring it back to its original or target asset allocation. Over time, market movements cause your portfolio’s balance to drift away from your intended plan. Rebalancing restores the proper mix of assets based on your risk tolerance and financial goals.
For example, if your target allocation is 70% stocks and 30% bonds, but after a strong year in the stock market your portfolio becomes 80% stocks and 20% bonds, you would rebalance by selling some stocks and buying more bonds to return to the 70/30 mix.
Why Rebalancing Is Important
- Controls Risk: Your asset allocation determines your portfolio’s risk profile. Without rebalancing, your portfolio can drift into a higher-risk or lower-return position than intended.
- Enforces Discipline: Rebalancing forces you to sell high (overperformers) and buy low (underperformers), which is the essence of smart investing — but emotionally difficult to do.
- Prevents Emotional Investing: It creates a system that keeps decisions rational and rule-based, not driven by fear or greed.
In essence, rebalancing keeps your portfolio aligned with you — your goals, your risk profile, and your timeline — rather than chasing the market.
How Often Should You Rebalance?
There are several approaches, but one of the most widely recommended is annual rebalancing. This involves reviewing your portfolio once per year and making necessary adjustments to bring it back to target allocation.
Why annually?
- Less time-consuming than monthly or quarterly methods
- Minimizes transaction costs and potential tax consequences
- Allows investments to grow without micromanagement
- Balances long-term discipline with practical convenience
Other options include rebalancing when any asset class deviates beyond a set threshold (e.g., ±5%), but this requires more frequent monitoring.
How Rebalancing Works Step-by-Step
- Set Your Target Allocation
For example: 60% stocks, 30% bonds, 10% cash. - Track Portfolio Value
At year-end, calculate the current value and percentage of each asset class. - Compare Current vs Target
Determine which assets are overweight (exceeded target) or underweight (below target). - Buy and Sell Accordingly
Sell a portion of the overperforming assets and use the proceeds to buy underperforming ones. - Reinvest Dividends or Add New Contributions
You can also use new money to restore balance without selling.
Example of Annual Rebalancing
Suppose your target allocation is:
- 60% stocks
- 30% bonds
- 10% cash
After a year of strong stock performance, your portfolio shifts to:
- 70% stocks
- 25% bonds
- 5% cash
Now, your portfolio is taking on more risk than intended. To rebalance:
- Sell some stocks to bring allocation back to 60%
- Use proceeds to buy bonds and replenish cash position
Result: You lock in some stock gains and restore risk alignment — without relying on guesswork or predictions.
Tax and Fee Considerations
While rebalancing helps control risk, it can trigger taxable events, especially in taxable brokerage accounts. Every time you sell assets for rebalancing, you may owe capital gains taxes.
To minimize taxes:
- Rebalance within tax-advantaged accounts (e.g., IRAs or 401(k)s)
- Use tax-loss harvesting where applicable
- Use new contributions to underweight assets instead of selling
Also, consider transaction fees. While many brokers offer commission-free trading, frequent rebalancing in small accounts may still lead to inefficiencies.
When Not to Rebalance
While rebalancing is generally beneficial, there are a few cases where it may not be necessary:
- In a very small portfolio — where the differences are marginal
- If transaction fees or taxes outweigh benefits
- When using a robo-advisor — which may rebalance automatically for you
In these cases, it’s still worth reviewing your allocation annually, even if you choose not to rebalance actively.
Rebalancing in Retirement
For retirees or those close to retirement, rebalancing becomes even more important. As you draw down funds, market fluctuations can quickly alter your allocation.
Strategies like the “bucket method” — separating cash, bonds, and stocks based on time horizon — help create a built-in rebalancing framework. Still, annual review is essential to ensure withdrawals don’t skew your risk too far off course.
Tools and Automation
Modern investors don’t have to rebalance manually. Many platforms and robo-advisors offer built-in rebalancing features, often triggered by thresholds or calendar intervals.
If you prefer DIY investing, tools like spreadsheets, portfolio tracking apps, or brokerage dashboards can make the process easier and more precise.
Final Thoughts
Rebalancing is not about market timing — it’s about risk management. By adjusting your portfolio annually, you align your investments with your goals, stay disciplined, and maintain a consistent approach no matter what the markets do.
Annual rebalancing may seem simple, but its power lies in that simplicity. It helps you systematically sell high, buy low, and keep your financial journey on track — year after year.
Ayzalme
Just a calm man, enthusiast for investing and technology.