If you picked an asset allocation a few years ago and have mostly left it alone since, I have some news for you. It’s probably not your asset allocation anymore. Some investments grow faster than others, and over time your carefully chosen 70/30 mix quietly turns into something closer to 78/22. Nobody asked it to do that, but that’s what portfolios do when you leave them alone.
Rebalancing is how you fix it. When you rebalance your portfolio, you bring it back to the mix you actually chose. It’s not the most exciting thing you’ll ever do with your money, but it’s one of the more useful ones. And the part most people don’t realize is that you can usually do it without selling much of anything, which means you can usually do it without handing the IRS a check.
Let’s go through how often to rebalance, how far off you should let things get before you do anything, and the order of operations that keeps your tax bill as small as possible.
Why your portfolio drifts
Say you start with $500,000 split 70% stocks and 30% bonds. That’s $350,000 in stocks and $150,000 in bonds. Then stocks have a great couple of years and go up 30%, while bonds basically stay flat.
Now you’ve got $455,000 in stocks and $150,000 in bonds, for a total of $605,000. Your stocks are now 75% of the portfolio and your bonds are 25%. You didn’t buy or sell anything. The market just moved the pieces around for you.
That might not sound like a big deal, and in a bull market it feels great. The problem shows up when stocks fall. You signed up for a 70/30 portfolio because that’s the amount of risk you were comfortable with. A 75/25 portfolio, or an 80/20 one after a few more good years, will drop more than you planned for in a crash. Drift tends to happen in the direction of more risk, because stocks usually grow faster than bonds.
Rebalancing is about risk, not returns
I want to be upfront about something. Rebalancing doesn’t necessarily make you more money. Over long stretches, stocks tend to beat bonds, so a portfolio that’s left alone will often end up with a higher balance than one that keeps trimming stocks back to target. If you only cared about the biggest possible number, you’d just hold 100% stocks and skip this whole conversation.
The point of rebalancing is to keep your risk where you decided it should be, during a period of relative market calm. It also has a nice side effect: it makes you sell some of what has done well and buy some of what has lagged. That’s the “buy low, sell high” advice everybody agrees with and almost nobody follows, because buying the thing that just went down feels terrible. Rebalancing turns it into a rule, so you don’t have to rely on your gut.
How often should you rebalance?
There are two common ways to decide when to rebalance, and you can use either one or both.
The first is the calendar approach. You pick a date and check your allocation once a year, or maybe twice. If you’re off target, you rebalance. If you’re close enough, you leave it alone and go do something more fun. I like picking a date you’ll actually remember, like your birthday, anniversary, or the week after you file your taxes, when you’re already in a numbers mood.
The second is the threshold approach. Instead of checking on a schedule, you rebalance whenever an asset class drifts a certain amount away from its target. This responds to what the market is actually doing, so you’re not ignoring a big move just because it isn’t your birthday yet.
Research on this, including work from Vanguard, generally finds that there’s no magic frequency. Rebalancing once a year or using reasonable thresholds tends to work about as well as anything else, and rebalancing much more often than that mostly adds work and trading costs without much benefit. Monthly rebalancing is a great way to stay busy. It’s not a great way to get better results.
A lot of people combine the two. They check once a year, but they only take action if something has drifted past their threshold. That keeps you from fiddling with your accounts constantly while still catching big moves.
What threshold should you use?
A common rule of thumb is to rebalance when any asset class is more than 5 percentage points away from its target. So if your target is 70% stocks, you’d act when stocks get above 75% or below 65%.
That works well for big slices of your portfolio, but it doesn’t work as well for small ones. If you have a 6% allocation to REITs, a 5-point band means you wouldn’t do anything until it hit 11% or fell to 1%, which is basically the whole range. That’s why some investors use what’s often called the 5/25 rule. You rebalance when an asset class is off by 5 percentage points or by 25% of its target, whichever comes first. For that 6% REIT slice, 25% of 6 is 1.5%, so you’d act if it moved above 7.5% or below 4.5%.
You don’t need to get too precise here. The best threshold is the one you’ll actually follow. If 5 points feels right to you, use it. If you’d rather use 3 or 10, that’s fine too. What matters is that you pick a number before the market gets weird, not while it’s happening.
The tax-friendly order of operations
This is the part that saves you real money. When you notice you’re off target, the instinct is to log in, sell the thing that’s too big, and buy the thing that’s too small. In a 401(k) or IRA, that’s fine. In a taxable brokerage account, selling investments that have gone up means paying capital gains tax. So before you sell anything in taxable, work through these steps in order.
- Send new money to whatever is underweight. If you’re still contributing to your accounts, this is the easiest fix there is. Stocks too high? Point your next few contributions at bonds until things even out. You’re not selling anything, so there’s nothing to tax. For a lot of people who are still working, this alone handles most of their rebalancing.
- Redirect your dividends and interest. Most brokerages automatically reinvest dividends back into the fund that paid them. In a taxable account, you can turn that off and send the cash wherever you need it instead. Your stock funds pay you dividends, and you use that cash to buy more bonds. You’ll still owe tax on the dividends, but you would have owed that anyway.
- Rebalance inside your retirement accounts. Trades inside a 401(k), 403(b), IRA, Roth IRA, or HSA don’t create a tax bill. If you have money in more than one type of account, you can often do all of your rebalancing in those accounts and never touch taxable. Remember to look at your whole portfolio as one big pie, not each account on its own.
- Take withdrawals from what’s overweight. If you’re already retired and living off your portfolio, you’re selling something every year anyway. Sell from whatever is above target. Your spending money does the rebalancing for you.
- Give away your winners. If you’re charitably inclined, donating appreciated shares from the asset class that’s overweight is one of the best moves out there. You generally avoid the capital gains tax, the charity gets the full value, and your allocation moves back toward target. Donor-advised funds make this pretty easy.
- Sell in taxable, carefully, as a last resort. If you still need to sell after all that, be smart about which shares you sell. Look for any lots that are sitting at a loss, since selling those can actually lower your taxes. Next, sell shares with a high cost basis, so the taxable gain is small. Choose shares you’ve held for more than a year, so you pay long-term capital gains rates instead of ordinary income rates. Most brokerages let you choose specific lots when you sell, so check that setting before you click the button. And if your income is low enough to land in the 0% long-term capital gains bracket, selling winners in taxable may not cost you anything at all.
One warning if you sell anything at a loss. The wash sale rule says that if you buy the same or a substantially identical investment within 30 days before or after selling it at a loss, you can’t claim that loss. That includes purchases in your IRA, and it includes automatic dividend reinvestments. Turning off reinvestment for a month or two around a sale can save you a headache.
Putting it together
Let’s go back to that $605,000 portfolio that drifted to 75% stocks. To get back to 70/30, you’d need about $423,500 in stocks and $181,500 in bonds. That means moving roughly $31,500 from stocks to bonds.
Say you’re still working and putting $2,000 a month into your 401(k). If you send all of that to your bond fund for a year, that’s $24,000. Your stock funds are also paying dividends. At around 1.5%, $455,000 in stock funds throws off about $6,800 a year. Send that cash to bonds instead of reinvesting it, and between the two you’re very close to target without selling a single share.
If you’d rather fix it faster, you could exchange some stock funds for bond funds inside your 401(k) or IRA, where it doesn’t trigger any tax. Either way, you never had to sell in your taxable account, and you never had to think about capital gains.
Mistakes to avoid
The biggest one is checking too often. If you look at your allocation every day, you’ll find a reason to rebalance every day. Pick your schedule or threshold and trust it.
Another is skipping the rebalance when it’s scary. In a big market drop, rebalancing means selling bonds and buying stocks while the news is telling you the world is ending. That’s exactly when it does the most good, and exactly when it’s hardest to do. Having your rules written down ahead of time helps a lot. (We advocate for creating an Investor Policy Statement, which is a document where you write down your investing goals and rules that you create in a time of market calm.)
People also forget about accounts. Your spouse’s 401(k), the old IRA from your first job, and the HSA you never look at all count. If you only rebalance the accounts you remember, you’re not really rebalancing.
Before you rebalance, look at your asset location. Make sure the type of account your assets are in makes sense, too.
Finally, watch out for funds that rebalance themselves. Target-date funds and balanced funds already keep their own mix. That’s great if they’re all you own, because they handle this for you. If you own one alongside other funds, just be aware that part of your portfolio is already being managed and plan around it.
The bottom line
Your first rebalancing doesn’t have to be a big event. Decide how often you’ll check, pick a threshold you can live with, and when it’s time, start with the moves that don’t cost you anything in taxes: new contributions, dividends, and trades inside your retirement accounts. Selling in taxable is the last step, not the first.
It’s not the kind of thing anybody brags about at parties. But keeping your portfolio at the risk level you chose, without paying extra tax to do it, is one of those small habits that makes a real difference over a few decades. Put a date on your calendar, and when it shows up, spend twenty minutes making sure your portfolio still looks like the one you meant to have.
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