Why Is It Important to Rebalance Your Portfolio?
So why rebalance? Because the financial markets are inherently unpredictable, and no asset class performs well in every economic cycle. When you rebalance, you are intentionally selling assets that have performed well and buying those that haven't—this is the essence of “buy low, sell high.” It sounds simple, but most people are wired to do the opposite: buy more of what’s hot and sell what’s not. By rebalancing, you can buck that trend and systematically take advantage of market volatility.
Here’s a critical stat for you: A study by Vanguard found that portfolios that were rebalanced regularly outperformed those that weren’t by about 0.40% annually. That might not seem like much at first glance, but over 20 or 30 years, it can lead to significantly larger retirement savings.
Let’s dig into why this matters even more:
Mitigating Risk: If you don't rebalance, your portfolio drifts away from your original risk tolerance. Imagine you started with 60% stocks and 40% bonds. After a bull market in stocks, your portfolio might now be 75% stocks and 25% bonds. This new mix is much riskier, and if a market downturn occurs, you could face bigger losses than you originally planned for. Rebalancing helps to return your portfolio to its intended risk level, which is essential for long-term financial health.
Psychological Control: Emotions drive bad investment decisions. In bull markets, investors become overconfident and pile more money into stocks, thinking they’ll never lose. In bear markets, fear drives them to sell off assets at rock-bottom prices. Rebalancing enforces discipline. It makes you sell winners when you’re feeling greedy and buy losers when you’re feeling fearful—effectively taking your emotions out of the equation.
Long-term Gains: Regularly selling high and buying low leads to compounded returns. Think of it as pruning the garden: you’re cutting back the overgrown plants (high performers) to give more sunlight to the underperforming ones (assets that have been temporarily beaten down). Over time, both get a chance to thrive, leading to a healthier overall garden (portfolio).
Rebalancing Is Not Time-Consuming: Many people believe rebalancing takes hours of research and strategic planning, but that’s not the case. Most financial platforms now allow for automatic rebalancing, where you can set up your target allocations and let the system do the heavy lifting for you. Alternatively, if you prefer a more hands-on approach, quarterly or annual reviews of your portfolio are sufficient for most investors.
So, when should you rebalance?
There are two schools of thought: calendar-based and threshold-based rebalancing. The calendar approach is straightforward—you rebalance at fixed intervals, like once a year. This method is simple and forces you to look at your portfolio regularly.
Threshold-based rebalancing, on the other hand, happens when an asset class deviates from your target allocation by a certain percentage, say 5%. This method is more flexible and allows you to react to market conditions. For instance, if your stocks have appreciated by 20% in just six months, you might want to rebalance sooner than if they only gained 5% over the same period.
A combined approach is often the most effective. By checking your portfolio at regular intervals and rebalancing when things get out of whack, you can stay on top of your investments without becoming obsessed.
Common Myths About Rebalancing:
“I’ll lose money if I sell my winners.”
False. By selling high and buying low, you’re positioning yourself for long-term success. What goes up must eventually come down, and by locking in profits, you reduce the risk of a major downturn wiping out your gains.“It’s too expensive.”
Not necessarily. Many brokers offer commission-free trades, and even if you do pay small fees, the long-term benefits far outweigh the costs. Plus, rebalancing can actually reduce taxes if done in tax-advantaged accounts.“I don’t need to rebalance; my portfolio is fine.”
Maybe today, but over time, your portfolio will drift. Small deviations from your target allocation might not seem like a big deal now, but over 5, 10, or 20 years, they can lead to drastically different results. Rebalancing ensures your portfolio remains aligned with your goals.
How to Rebalance Effectively:
Step 1: Assess Your Current Portfolio
First, look at the current distribution of assets in your portfolio. Compare this with your target allocation. If they are significantly different, it’s time to take action.Step 2: Sell the Overweight Assets
This can be tough, especially if those assets have been performing well. But remember, rebalancing isn’t about predicting the future—it’s about maintaining your risk profile.Step 3: Buy the Underweight Assets
The capital raised from selling your overweight assets should be used to purchase underperforming or underweight assets. This helps bring your portfolio back to its intended balance.Step 4: Automate the Process
If you’re worried about sticking to your plan, automation can be a lifesaver. Many investment platforms offer automatic rebalancing tools that can help you stay disciplined.
Data Table: How Rebalancing Impacts Portfolio Performance
| Year | Portfolio Without Rebalancing (%) | Portfolio With Rebalancing (%) |
|---|---|---|
| 2020 | 12.5% | 13.0% |
| 2021 | 8.0% | 8.5% |
| 2022 | -5.0% | -4.6% |
| 2023 | 10.0% | 10.4% |
The Bottom Line: Rebalancing may feel counterintuitive because you’re selling winners and buying losers, but it’s one of the most effective ways to grow wealth while controlling risk. It allows you to keep your emotions in check, maintain your desired risk level, and improve your long-term investment performance. Whether you choose to rebalance once a year or when your asset allocations deviate significantly, the key is consistency.
Don’t let inertia stop you from taking action—your future self will thank you for the discipline you showed today.
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