Say you set up a hypothetical $100,000 portfolio at the start of the year: 60% in a stock index fund, 40% in a bond fund. It’s a good year for stocks. They gain 25%, while bonds eke out 2%. By December your account holds $75,000 in stocks and $40,800 in bonds, a total of $115,800.
That looks like pure good news, and mostly it is. But your mix is now about 65% stocks, not 60%. You didn’t decide to take more risk. The market decided for you. Another strong year or two and you could be at 70% or more, sitting in a portfolio that would fall harder in a downturn than the one you signed up for.
Rebalancing is the act of moving back. In this example, selling about $5,500 of stocks and buying bonds brings you back to $69,480 in stocks and $46,320 in bonds, a 60/40 split again.
What matters most
- Rebalancing is about risk, not returns. Its job is to keep your portfolio as aggressive as you chose, no more and no less.
- The method matters less than the habit. Once a year or whenever an asset drifts five points both work. Never is what causes trouble.
- Taxes decide the mechanics. Do the selling inside retirement accounts or use new contributions, and rebalancing costs little or nothing.
Why letting winners run can backfire
The argument against rebalancing goes like this: stocks usually beat bonds over long periods, so why sell the winner? Over decades, a portfolio left alone will typically drift toward stocks and may well end with a higher balance.
The catch is that it also ends with a different risk profile than you chose. A retiree who meant to hold 50% stocks and drifted to 75% just before 2008 found out what that means in one bad year. The original allocation was supposed to reflect how much of a drop you could stomach and how soon you need the money. Our guide to asset allocation by age covers how to set that target in the first place. Rebalancing is just honoring it.
There’s a secondary benefit too. Rebalancing makes you trim what has risen and add to what has lagged. That’s “buy low, sell high” done mechanically, without any forecasting. It doesn’t guarantee better returns, but it does stop you from chasing the hot asset with all your money at the worst possible time.
Calendar or threshold: two ways to decide when
Calendar rebalancing
You pick a date and check once a year, or every six months, and reset to target. It’s simple and easy to remember. Pick a date that already has a financial ritual attached, such as your birthday, tax season or the week you review employer benefits. Research from fund companies has generally found that rebalancing more often than annually adds little except trading activity.
Threshold rebalancing
You set a tolerance band, often 5 percentage points, and rebalance only when an asset class moves outside it. With a 60/40 target, you’d act if stocks hit 65% or fell to 55%. This responds to big market moves faster than a calendar does and skips years when nothing much happened.
A combined approach
Many investors check on a schedule but act only if the drift crosses a threshold. Look once a year; if stocks are at 62%, leave it alone; if they’re at 67%, rebalance. It keeps the work small and the trades meaningful.
How to rebalance without a tax bill
In a taxable brokerage account, selling a fund that has gained value creates a capital gain, which is taxable. So the order in which you use these tools matters.
- Direct new money to the underweight asset. If bonds are short, send your next several contributions there. For someone adding money regularly, this alone often handles routine drift.
- Rebalance inside tax-advantaged accounts first. Trades within a 401(k) or IRA don’t trigger tax. If you hold bonds in your 401(k) and stocks in a taxable account, you can shift the overall mix by changing only the 401(k) funds.
- Redirect dividends and interest. Instead of auto-reinvesting payouts into the same fund, send them to cash and use them to buy the lagging asset.
- Sell in taxable accounts last. When you have to, look for shares with the smallest gains, or harvest a loss elsewhere to offset the gain. The IRS explains how gains and losses net out in Topic 409.
The set-it-and-forget-it option
Target-date funds and balanced funds rebalance internally. You own one fund, and its managers keep the stock and bond mix on target, shifting it more conservative as the target date approaches. Many 401(k) plans also offer an automatic rebalancing feature that resets your chosen mix on a schedule. If you know you won’t remember to do it yourself, either option removes the decision entirely. Just check the expense ratio; convenience sometimes comes at a cost.
Frequently asked questions
Should I rebalance during a market crash?
If your rules say to, yes. A sharp drop can push stocks well below target, and rebalancing means buying stocks while they’re down. It feels wrong in the moment, which is exactly why having a rule set in advance helps. Our piece on what to do when the market drops covers the rest of that situation.
Do I need to rebalance across every account separately?
No. Think of your 401(k), IRA and taxable accounts as one portfolio. What matters is the combined mix. Treating them as a whole is what lets you do the selling where it’s tax-free.
Does rebalancing apply if I own only one target-date fund?
Not really. The fund handles it for you. The question only comes back if you add other holdings alongside it.
How small a drift is worth ignoring?
A couple of percentage points usually isn’t worth trading over, especially in a taxable account. Small drifts tend to correct themselves or get absorbed by your next contributions.
A rebalancing routine
Write down your target mix, in one sentence: “60% stocks, 40% bonds” or “80% U.S. and international stocks, 20% bonds.” Pick one date each year to check it. Add up every account and calculate the actual percentages. If anything is more than five points off, fix it, starting with new contributions, then trades inside retirement accounts, then taxable sales as a last resort. Note what you did and when. The whole process takes under an hour, and it means your portfolio’s risk level is something you choose rather than something the market chooses for you.
