Investing · Reference

Rebalancing: What It Costs and What It Buys

Selling what went up to buy what went down. The arithmetic, the tax bill, and why calendar rules beat instinct.

A portfolio set at 60% equities and 40% bonds does not stay there. Equities are more volatile and, over most windows, rise faster, so the equity share grows. Nobody decides this; it is the arithmetic of leaving things alone.

The drift, concretely

Start at 60/40 with $100,000. Suppose over three years equities gain 30% and bonds gain 6%. The equity sleeve is now $78,000 and the bond sleeve $42,400 — a total of $120,400, of which equities are 64.8%. Nothing dramatic has happened and the portfolio is already carrying noticeably more risk than the one that was chosen.

Run that through a long bull market and the drift is not 5 points, it is 15 or 20. The portfolio arrives at the next downturn holding the allocation its owner explicitly rejected at the start.

What rebalancing actually does

Restoring the weights forces a sale of whatever has risen and a purchase of whatever has lagged. Two things follow, and only one is the one people cite.

It controls risk. This is the real justification. The allocation you chose stays the allocation you hold.
It sometimes adds return. When assets are volatile and mean-reverting, systematically trimming winners and topping up laggards earns a small premium. When one asset trends strongly for years, the same discipline costs return — you sold the thing that kept going up. Anyone presenting rebalancing as a reliable return enhancer is quoting the favourable case.

The costs, which are not zero

Tax. In a taxable account, selling an appreciated holding realises a gain. This is the dominant cost for most people and it is why rebalancing with new contributions — directing fresh money at the underweight sleeve — is usually better than selling anything.
Spreads and commissions. Small on liquid funds, real on thin ones.
Being wrong more often than not, by design. You will frequently sell something that then rises further. That is the trade being made, not a failure of it.

Calendar or threshold

Two rules in common use. Calendar: rebalance on a fixed date, annually or semi-annually. Simple, and it caps how often you trade. Threshold: rebalance when a sleeve drifts more than a set distance from target — five percentage points is the usual figure. More responsive, and it does nothing at all in a quiet year.

Their long-run results are close enough that the difference is dominated by tax and by whether you actually follow the rule. The one approach with a clear record of failure is doing it by feel, because by feel means selling after a fall and buying after a rise.

The prerequisite

Rebalancing between two holdings that move together achieves nothing — there is no divergence to harvest and no risk being controlled. It only does work when the sleeves are genuinely different, which is a question about correlation and is worth checking in the correlation finder before designing a schedule around it.

Reference material, not investment advice. Tax treatment depends on your jurisdiction and circumstances.