What is portfolio rebalancing and why should you care?
E*TRADE Capital Management
When you think about your portfolio's asset allocation, there's a related idea—rebalancing—that goes hand-in-hand with it. Essentially, rebalancing means selling some assets in your portfolio and buying others in order to maintain your target asset allocation.
Why rebalance?
Over time, changes in the market will likely cause your portfolio to drift away from the asset allocation you want. Some assets may perform well and become a larger portion of your portfolio, while others may do poorly and shrink as a percentage of your investments.
When a portfolio drifts away from its target asset allocation, it may get riskier or, conversely, more conservative with lower potential gains. By rebalancing, you can bring your portfolio back into alignment with your risk tolerance and overall investing strategy.
How it works
The basic idea is simple. Let's say that you start out with an asset allocation of 60% stocks and 40% bonds. Imagine that, over time, the market value of your stocks grows, but your bonds don't, and you end up with 70% of your portfolio value in stocks and only 30% in bonds. To rebalance, you would sell some of the stocks and buy more bonds—enough of both to bring the percentages back to 60/40.
Of course, your asset allocation is probably more granular than simply stocks vs. bonds. Let’s say that within your stock holdings, your asset allocation calls for certain percentages of large cap, mid cap, and emerging market stocks. Rebalancing should correct drifts away from your targets within those sub-categories, too.
When to rebalance: two approaches
Calendar-based
Some portfolios are rebalanced on a regular timetable — quarterly and annual rebalancing are common schedules.
- Pros: It's simple to implement.
- Cons: Rebalancing may be out-of-sync with the actual changes in your portfolio's asset allocation. For example, a significant drift could happen between rebalancing intervals. Conversely, rebalancing could occur even if there was only a small change in your portfolio, which might trigger an unwanted taxable capital gain.
Trigger-based
With this method, the portfolio is rebalanced when it drifts beyond certain pre-determined limits—for example, if an asset class changes by 10% or more relative to its target allocation.
- Pros: Rebalances promptly when the portfolio drifts too far but doesn't rebalance unnecessarily.
- Cons: More difficult to implement. Also, in periods of high market volatility, rebalancing could be triggered several times, resulting in higher transaction costs and potential taxable capital gains.
There’s one more important point to remember: any time rebalancing is done, it may generate taxable capital gains.
Ultimately, rebalancing is one of the most critical parts of managing a portfolio, and it is key to keeping your investments aligned with your long-term goals.
Rebalancing in action
E*TRADE Core Portfolios, our automated investment management solution, provides a good illustration of how a rebalancing plan may work. On top of semiannual rebalancing, a Core Portfolios account is checked every day and will be rebalanced if any asset class has drifted 10% above or below its target allocation. This is an example of both calendar-based and automatic trigger-based rebalancing.1
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