AAII How-To
2 0 A A I I J o u r n A l J A N UA RY 2 0 2 2
Rebalancing is the process of bringing a portfolio’s
allocations back to their targets. Specically, rebalanc-
ing involves selling a portion of overweighted investments
and buying more of the underweighted investments.
Rebalancing is typically done at the asset class (stocks,
bonds, etc.) or asset class category (large-cap stocks,
small-cap stocks, etc.) level.
While rebalancing can have advantages in terms of
maintaining a desired allocation, rebalancing too fre-
quently can result in undesired costs. In this article, we
discuss why and when you should rebalance a portfolio.
Why Rebalance a Portfolio?
A portfolio’s allocation will shift over time based on the
relative performance of each investment held. Historically,
stocks have been the highest-performing asset class. This
means that any portfolio comprising just stocks and bonds
incurs a rising allocation to stocks over time if periodic
rebalancing is not done.
A simple portfolio allocation of 50% large-company
stocks and 50% long-term government bonds demon-
strates this. Such a portfolio has experienced volatility of
11.1% (as measured by standard deviation) in its returns
over the period from 1926 to 2020 when rebalanced annu-
ally back to its 50/50 allocation target, according to the
2021 SBBI Yearbook.
When the same portfolio was never rebalanced, its
allocation shifted from 50% stocks/50% bonds in 1926 to
98.3% large-cap stocks and 1.7% long-term bonds at the
end of 2020. This shift resulted in the never-rebalanced
portfolio incurring 40% greater volatility than the portfolio
that was rebalanced annually.
Our ongoing study of portfolio rebalancing nds that
rebalancing preserves diversication and maintains risk
reduction over shorter time frames as well. A periodically
rebalanced portfolio following AAII’s moderate allocation
model of 60% diversied stocks and 40% bonds over
the period from 1988 through 2020 maintained the 60/40
allocation. This portfolio ended 2020 with an allocation of
63.6% in stocks and 36.4% in bonds. A non-rebalanced
portfolio starting with the same allocation in 1988 ended
2020 with an 86% allocation to stocks and 14% alloca-
tion to bonds. The non-rebalanced portfolio’s drift caused
it to experience 20% greater volatility than the rebalanced
portfolio.
As you can see, periodic rebalancing preserves the
diversication and risk reduction benets of a given allo-
cation. Not rebalancing causes these benets to be dimin-
ished, or even be eliminated, over time.
Portfolio Rebalancing Is a Buy Low, Sell
High Strategy
In addition to preserving an allocation, rebalancing
prompts an investor to buy low and sell high. Dollars are
shifted out of the best-performing assets and invested into
the worst-performing assets.
This can be particularly benecial during periods when
optimism is too high or too low. If, say, stocks are in an
extended bull market with high valuations, rebalancing
prompts an investor to take prots. If stocks are experienc-
ing a bear market, rebalancing prompts an investor to buy
equities at depressed prices. The same applies to other
asset classes included in a portfolio, be it bonds, publicly
traded real estate, commodities or cryptocurrencies.
The Best Time to Rebalance
The frequency and timing at which a portfolio should be
rebalanced depends on the level of simplicity you desire.
Annual rebalancing is the simplest approach. Each
year, the portfolio’s asset class and asset class category
allocations are adjusted back to their targets. Doing this
at the start of each year attaches the task to an easy-to-
remember date and makes use of year-end data.
Figure 1 shows a 60% stock/40% bond portfolio com-
prising ve exchange-traded funds (ETFs). The portfolio
was created on December 31, 2020, and is being tracked
via AAII’s My Portfolio tool.
A quick glance shows that bonds—represented by
the Vanguard Intermediate-Term Treasury Index ETF
(VGIT)—is underweighted, with a portfolio weighting of
35.36% as of press time. Assuming the allocations did
not change signicantly at the end of 2021, an investor
would have sold shares of the large-cap (S&P 500 index),
mid-cap and small-cap ETFs and used the proceeds to
purchase shares of the bond ETF on the rst trading day
of 2022. The dollar amounts would be the equivalent of
what is required to bring the Vanguard Intermediate-Term
Treasury Index ETF’s portfolio weight back up to 40%.
An alternative is to use a threshold-based approach.
Rather than rebalancing on a specic date, rebalancing
is only done when the allocation of one or more of the
asset classes or asset class categories exceeds a certain
threshold.
Bands of ve or 10 percentage points are often used in
such approaches. Under a 5% band threshold approach,
the portfolio shown in Figure 1 would not be rebalanced
because the bond weighting is within ve percent-
age points of its 40% allocation target. The bond ETF’s
When to Rebalance a Portfolio
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A A I I J o u r n A l J A N UA RY 2 0 2 2 2 1
portfolio weighting would have to fall below 35% (ve
percentage points below 40%) or rise above 45% (ve
percentage points above 40%) to prompt rebalancing.
(Portfolio weightings below 10% or above 20% for any of
the stock ETFs would also prompt rebalancing.)
The two approaches to rebalancing can be combined.
An investor can check to see if any of their allocations
exceed a certain threshold on a regular date, such as the
beginning of a new year. If all allocations are within an
acceptable range, no rebalancing is done. If any asset
class or asset class category is above or below the pre-
determined thresholds, the portfolio is rebalanced on that
date.
AAII members can use the portfolio weight in the right-
hand column of the Portfolio tab of My Portfolio to see the
current weights of their holdings. A+ Investor and AAII
Platinum subscribers can use the Diversication Analyzer
tab to see a percentage breakdown of their allocations by
domestic stocks, foreign stocks, bonds, cash and other.
How to Rebalance a Portfolio
If rebalancing is needed, there are a few ways investors
can go about it.
The rst is to rebalance the portfolio on a single day.
This involves selling a portion of the overweight assets
and immediately investing the proceeds into the under-
weighted assets. It has the advantage of simplicity. It also
works well when prices of the underweighted asset class
or category are unusually low, such as during a bear mar-
ket for stocks. This strategy can be the least tax-friendly,
however.
A second strategy is to adjust future contributions. New
dollars added to the portfolio are used to increase expo-
sure to the underweighted asset classes or categories.
This avoids capital gains taxes from being realized. For
portfolios of signicant size, new contributions may not be
large enough to fully bring the portfolio’s overall allocation
back to its target.
A third strategy is to use the portfolio’s cash proceeds
to increase the allocation of the underweighted asset
classes and categories. Dividends, distributions, interest
income and the proceeds of large positions that are sold
for reasons other than rebalancing (e.g., a stock meets the
investor’s sell rules) all provide cash proceeds that can
be used for rebalancing. As is the case with new contri-
butions, the cash proceeds may not be large enough to
rebalance the portfolio.
Retirees and other investors who are taking withdraw-
als can use a fourth strategy. Investments held in over-
weighted asset classes and categories are pared down
rst to free up cash to fund withdrawals. This strategy uses
transactions that would have otherwise occurred to rebal-
ance the portfolio. Again, size matters as the withdrawals
may not be large enough to fully rebalance the portfolio.
Any of these strategies can be combined when rebal-
ancing. An investor can combine
regular savings contributions with
cash proceeds from dividends and
interest income to rebalance their
portfolio over a certain period. A
retiree can sell overweighted assets
to satisfy the year’s required mini-
mum withdrawal and complete any
remaining rebalancing at once. The
correct mix depends on the inves-
tor’s preferences and tax exposure.
If Allocation Matters to
You, Then You Should
Rebalance
The big benet of rebalancing
is preserving your target alloca-
tion strategy. If you have a port-
folio allocation that you wish to
follow, then you should incorpo-
rate plans to periodically rebal-
ance your portfolio to maintain that
allocation. ▪
—Charles Rotblut, CFA,
AAII Journal editor
FIGURE 1
60% Stock/40% Bond Portfolio Tracked in My Portfolio
The target allocation is 15% ineach stock category of large-cap, mid-cap, small-cap
and international stocks and 40% in intermediate-term bonds. The portfolio wasstarted
at the end of 2020. An investor seeking to maintain this allocation would rebalance the
portfolio either on aspecifieddate (e.g.,at the start of each year) or when one or more of
the allocations moves too far off-target.
Source: AAII.com. Data as of December 10, 2021.
