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rebalancing

Also called: rebalance

Bringing a portfolio back to its target mix by selling some of what grew and buying what fell behind.

Rebalancing means bringing a portfolio back to its target mix by selling some of what grew and buying what fell behind. If your plan is 60% stocks and 40% bonds and a strong stock market pushes stocks to 70%, rebalancing moves the extra 10 points back into bonds.

Without it, a portfolio drifts toward whatever rose most, which is usually the riskier part. The plan said 60/40, but years later you may own something close to all stocks without ever deciding to. Rebalancing keeps the risk you chose; it is not a way to earn more.

There are two common rules: rebalance on a calendar date, for example once a year, or only when a weight drifts beyond a band, for example 5 points from target. A band trades less often. Directing new monthly contributions to the part that is behind can do much of the work without selling, which also avoids costs and taxes.

Example

Zapas tests a 60/40 portfolio started with $1,000 over 40 synthetic years, in money terms. Never rebalanced, it ends at $23,453, but only because stocks drift to 81.8% of the portfolio by year 20 and 88.5% by year 40; its worst fall is −33.8%. Rebalanced every year, it ends at $19,960 with a worst fall of −22.8% and 39 rebalances. With a 5-point band it ends at $20,173, the same −22.8% worst fall, and only 10 rebalances.

The never-rebalanced portfolio earned more by quietly taking more risk than planned. The data is invented for the course.

Common mistakes

  • Judging rebalancing only by the final balance instead of by the risk taken.
  • Rebalancing so often that trading costs and taxes eat the benefit.
  • Skipping the rebalance after a crash because buying stocks feels wrong.
  • Investments can fall, and you can get back less than you put in.

Learn it in the course