Rebalancing a Portfolio

A portfolio that starts with 70% equities and 30% bonds, after a five-year bull market, might drift to 85% equities and 15% bonds — simply because equities outperformed. That 85/15 portfolio has dramatically higher volatility and drawdown potential than the intended 70/30 allocation. The investor's risk profile hasn't changed; their portfolio's risk has unknowingly increased. Left unaddressed, drift compounds: prolonged bull markets make portfolios riskier just as valuations become elevated and future expected returns decline.

Drift also causes allocation to deviate from the optimal diversification structure. After a technology sector boom, a diversified portfolio might find that technology stocks constitute 40% of its equity allocation rather than the intended 25%. The portfolio now has concentrated technology factor exposure rather than the intended broad market exposure. Rebalancing corrects both the asset class drift and the sector/factor concentration that develops from differential return streams.

Calendar rebalancing resets allocation on a fixed schedule — annually, semi-annually, or quarterly. It is simple to implement and ensures the portfolio never drifts for more than a defined period. Annual rebalancing is the most common calendar approach for individual investors and has strong empirical support. Quarterly rebalancing incurs more transaction costs and tax friction without proportionally improving outcomes.

Threshold rebalancing (or 'band rebalancing') triggers action when any allocation drifts more than a specified percentage from target — commonly 5 percentage points. If equities target is 70% and drifts to 75%, rebalancing is triggered. Threshold rebalancing captures market momentum better (letting winners run within the band) and trades less frequently in stable markets — only 30-40% as often as quarterly calendar rebalancing in typical market conditions. The research mildly favors threshold rebalancing on a risk-adjusted basis, but the difference is small compared to the benefit of rebalancing at all versus not rebalancing.

In taxable accounts, selling appreciated positions to rebalance generates capital gains taxes. Tax-smart rebalancing minimizes this friction through several techniques. New contributions: direct new cash into underweight asset classes rather than buying equally across all positions and selling overweights. Dividend reinvestment: repoint dividend reinvestment into underweight classes. Tax-loss harvesting: if underperforming positions have unrealized losses, selling to harvest the loss also rebalances in the desired direction. Asset location: hold assets requiring frequent rebalancing (higher-turnover strategies) in tax-advantaged accounts where rebalancing incurs no immediate tax cost.

The net benefit of rebalancing is the reduction in portfolio variance relative to a buy-and-hold strategy, less transaction costs and taxes. For taxable accounts in high-capital-gains-tax jurisdictions, this calculation often favors less frequent rebalancing (annual or threshold-based at wide bands) rather than tight quarterly bands. The goal is maintaining the risk profile without excessive tax drag — which threshold rebalancing with 5-7 percentage point bands typically achieves efficiently.