Rebalancing is a risk-control mechanism first and a return strategy a distant second. Its job is to stop a portfolio from quietly becoming more aggressive than intended after a long run in one asset class.
It is uncomfortable by construction. Rebalancing means selling the thing that has done well to buy the thing that has done badly, which is the opposite of what recent performance suggests and precisely why a rule beats a judgement call.
The two common approaches are calendar-based — rebalance every year on a set date — and threshold-based, rebalancing whenever an asset class drifts more than a set percentage from target. Threshold rules trade less often in calm markets and react faster in turbulent ones.
Costs and taxes matter. In a taxable account, rebalancing can realise gains, so directing new contributions toward the underweight asset is often cheaper than selling. In a tax-sheltered account that constraint disappears.
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See also
- Asset allocation — The split of a portfolio across asset classes — equities, bonds, cash, and others — which is the primary determinant of both its expected return and its volatility.
- Glide path — A predetermined schedule that shifts a portfolio from higher-risk to lower-risk assets as a target date approaches — the mechanism inside target-date funds.