When it comes to rebalancing investments, understanding the how and when of adjusting your portfolio is key to maintaining a risk profile that aligns with your long-term objectives.

What is Rebalancing?

Rebalancing is the deliberate action of adjusting the asset allocation in a portfolio back to its original or desired mix. As time progresses and market conditions change, your initial asset allocation will naturally drift due to varying rates of return from different assets.

Rebalancing aims to mitigate risk by periodically reallocating the investment assets, ensuring that your portfolio remains aligned with your financial goals and risk tolerance.

„What does his lucid explanation amount to but this, that in theory there is no difference between theory and practice, while in practice there is?“
Benjamin Brewster

Rebalancing Methods: Time-based vs. Threshold-based

There are two primary methods to decide when to rebalance: time-based and threshold-based. A time-based strategy sets regular intervals for rebalancing, such as every quarter or year. This approach is simple but might not capture rapid market shifts.

A threshold-based strategy triggers rebalancing when an asset class's proportion deviates from its target allocation by a pre-set percentage, like 5% or 10%. This approach is more responsive to market conditions but can involve more frequent trading and, thus, potentially higher costs.

"The act of rebalancing forces the disciplined and systematic buying low and selling high."
David Swensen

Costs and Tax Implications of Rebalancing

It's crucial to account for the expenses associated with rebalancing, including trading fees and potential tax consequences. While trading fees have generally come down, they can still add up, especially for more active rebalancing strategies.

The tax consequences can be significant as well, particularly if you're realizing capital gains when selling assets. Some investors choose to rebalance in tax-advantaged accounts to mitigate this issue.

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Michael Saylor (CEO, MicroStrategy)

The Psychology of Rebalancing

Psychological factors often prevent investors from rebalancing effectively. The emotional pain associated with selling off outperforming assets can be a significant barrier, as can the fear of locking in losses when an asset class is underperforming.

Understanding these psychological impediments can prepare you to better adhere to your rebalancing strategy, ensuring that emotions do not get in the way of sound financial planning.

“Short-cuts are timesavers for a reason: they omit details that can differentiate a profitable decision from one that you regret.”
Coreen T. Sol

When not to rebalance

Though rebalancing is generally a wise strategy, there are times when it may not be advisable. These could include situations where the transaction costs or tax implications outweigh the potential benefits, or when the market is showing signs of extreme volatility, which might make immediate rebalancing counterproductive.

Some financial advisors also caution against rebalancing if you have a significant upcoming liquidity need that would necessitate selling assets.

The beauty of periodic rebalancing is that it forces you to base your investing decisions on a simple, objective standard.
Benjamin Graham