Portfolio rebalancing: calendar vs threshold methods

Written by the Tactfolio research teamPublished 5 min read

Portfolio rebalancing means bringing your investments back to the mix you chose, after market moves push them off target. Say you want 60% stocks and 40% bonds, and a rally lifts stocks to 66%. You sell some stocks and buy bonds to get back to 60/40. You can rebalance on a calendar, when the mix drifts past a set limit, or both.

Key points#

  • Over time, winners grow into a bigger share of your portfolio. That raises your risk without you choosing it.
  • Calendar rebalancing resets the mix on a schedule, like once a year.
  • Threshold rebalancing resets it only when a holding drifts past a set limit, like 5 percentage points.
  • The goal is to keep your risk where you set it, not to raise returns.
  • Selling in a taxable account can trigger taxes. Rebalancing with new money or inside a retirement account can avoid that.

What is portfolio rebalancing?#

Rebalancing is selling some of what has grown too big and buying what has shrunk, to return to your target mix. The SEC’s Investor.gov says it keeps a portfolio from leaning too hard on one kind of asset. It also notes that rebalancing makes you “buy low and sell high” by trimming winners and adding to laggards.

Your target mix is your asset allocation: how you split money between stocks, bonds, cash and other assets. Picking that mix is step one. Rebalancing is how you keep it.

Why does a portfolio drift? A 60/40 example#

A portfolio drifts because its parts grow at different speeds. Here is a simple case.

Say you start with $10,000: $6,000 in a stock fund and $4,000 in a bond fund. Over the next year, stocks rise 30% and bonds stay flat.

StartAfter one yearMix after one yearAfter rebalancing
Stocks$6,000 (60%)$7,80066%$7,080 (60%)
Bonds$4,000 (40%)$4,00034%$4,720 (40%)
Total$10,000$11,800$11,800

Without doing anything, you now hold 66% stocks. That is a riskier portfolio than you chose. To get back to 60/40, you sell $720 of stocks and buy $720 of bonds.

Left alone for years, a portfolio usually drifts toward stocks, since they tend to grow faster. Then a crash hits harder than you planned for.

Calendar vs threshold rebalancing#

There are three common ways to decide when to rebalance. Vanguard describes all three.

MethodHow it worksGood forWatch out for
CalendarReset on set dates, like every 6 or 12 monthsPeople who want a simple routineIt may trade when the drift is tiny
ThresholdReset when a holding is off target by a set amount, like 5 pointsTrading only when it mattersYou have to keep checking
BothCheck on set dates, but only trade if drift passes the limitFewer, more useful tradesA few more rules to follow

Investor.gov says rebalancing “tends to work best when done on a relatively infrequent basis”. Vanguard says that for many investors, an annual rebalance works best (Vanguard).

Two classic strategies show the difference. The 60/40 portfolio on Tactfolio is a calendar rule. It resets to 60/40 at the end of every month. The Permanent Portfolio is closer to a threshold rule. It holds 25% each in stocks, long-term Treasuries, gold and cash. It checks once a year and resets only if a holding has drifted below 15% or above 35%.

How do you rebalance?#

You can rebalance in three ways, per Investor.gov:

  1. Sell and buy. Sell some of what is too big and buy what is too small.
  2. Add new money. Put fresh cash only into what is too small.
  3. Steer your contributions. If you invest on a schedule, send more of each deposit to the smaller part until the mix is back. This pairs well with dollar-cost averaging.

The second and third ways do not require selling, so they can avoid taxes and trading costs.

What about taxes and costs?#

Selling at a gain in a regular brokerage account can create a capital gains tax bill. The IRS taxes gains on assets held longer than one year at long-term rates, and gains on shorter holdings as ordinary income (IRS Topic 409).

Inside a 401(k) or IRA, trades do not create a tax bill at the time. That makes those accounts a natural place to rebalance. Our IRA vs 401(k) guide explains them.

Each trade can also carry a bid-ask spread and, at some brokers, a commission. Rebalancing too often can add costs without lowering risk much.

Common mistakes#

  • Never rebalancing. A 60/40 mix can quietly become 80/20 after a long bull market.
  • Rebalancing too often. Trading every small wiggle adds costs and taxes.
  • Selling in a taxable account when new money could fix the drift.
  • Changing the target after a scary month. That is market timing, not rebalancing.
  • Mixing up rebalancing with tactical asset allocation. Rebalancing returns to a fixed mix. Tactical rules change the mix on purpose.

Try it on Tactfolio#

In the strategy builder, you can set target weights for a few ETFs. Then you pick when to reset them: on a schedule, such as monthly or yearly, or when a holding drifts a set number of points. Then you can compare the hypothetical backtests of monthly and yearly resets on the same dates. Stock and ETF strategies run on daily prices, hold long positions only, and can trade in your own Alpaca account.

Common questions#

How often should you rebalance your portfolio?#

There is no single right answer. Investor.gov mentions every 6 or 12 months as common choices. Vanguard says a yearly rebalance works well for many investors. A threshold, such as 5 percentage points off target, can cut needless trades.

Does rebalancing improve returns?#

Not reliably. Its main job is to keep your risk at the level you chose. In a long bull market, rebalancing can even lower returns, because it keeps selling the asset that is rising.

What is the 5% rule for rebalancing?#

It is a common threshold rule. You rebalance when any part of your mix drifts 5 percentage points or more from its target. Vanguard uses this example: a 70/30 portfolio that drifts to 76/24 would be due for a reset.

Should I rebalance in a down market?#

A rebalancing rule will often tell you to buy the asset that fell, which can feel hard. That is the “buy low” part of rebalancing. If you follow a rule, keep following it in both up and down markets.

Sources

Put it into practice