What rebalancing is and why it works

Rebalancing is the least exciting and most important maintenance task in investing. It's the financial equivalent of changing your oil — unglamorous, easy to postpone, and expensive to skip.

Here's the problem rebalancing solves: markets move, and when they move, your portfolio drifts away from the allocation you carefully chose. A portfolio that started the year at 60% stocks and 40% bonds might end the year at 68% stocks and 32% bonds if stocks rally 20% and bonds return 3%. After two good years, you could be at 75/25. After five, you might be at 85/15.

You didn't choose 85/15. You chose 60/40 for a reason — because that's the level of risk you can tolerate. Drift makes your portfolio riskier without your consent.

How rebalancing works

The mechanics are simple:

1. Compare your current allocation to your target.
2. Sell what's above target and buy what's below target until you're back in balance.

If stocks surged and you're at 70/30 instead of 60/40, you sell stocks and buy bonds. If stocks crashed and you're at 50/50, you sell bonds and buy stocks.

Notice what this forces you to do: sell your winners and buy your losers. That's systematically selling high and buying low — the opposite of what most investors do instinctively. Most people want to buy more of whatever just went up and sell whatever just went down. Rebalancing overrides that instinct with discipline.

Calendar vs. threshold rebalancing

There are two common approaches:

Calendar rebalancing checks your allocation at fixed intervals — quarterly, semi-annually, or annually. Simple to implement, but you might rebalance when nothing has drifted meaningfully, or miss a big drift between check dates.

Threshold rebalancing triggers a rebalance whenever any asset class drifts beyond a set band — typically 5 percentage points. If your target is 60% stocks, you rebalance when stocks hit 65% or drop to 55%. This approach is more responsive to actual market conditions and generally produces better risk-adjusted results in backtests.

The evidence slightly favors threshold rebalancing, but the honest truth is that either approach works well. What doesn't work is not rebalancing at all.

The risk control that pays for itself

Rebalancing won't make you rich. Over long periods, an unrebalanced portfolio often produces slightly higher total returns — because stocks outperform bonds over time, and an unrebalanced portfolio gradually becomes 100% stocks.

But total return isn't the right measure. The right measure is risk-adjusted return: how much return did you get per unit of volatility? On that metric, rebalanced portfolios win consistently. They capture most of the return with substantially less risk, which means fewer stomach-churning drawdowns and a dramatically lower chance of panic-selling at the bottom.

A portfolio that returns 9% with 25% drawdowns will leave you wealthier than one that returns 10% with 50% drawdowns — because you'll actually hold the first one.

What this means for the Hendersons

With $1.4M and retirement seven years away, the Hendersons can't afford to let their portfolio drift to 80% stocks just because the bull market was strong. A 55/40/5 target with a 5-point rebalancing band means they'll systematically trim stock gains and add to bonds as they approach retirement — automatically reducing risk as the stakes get higher. Their advisor handles this, but understanding the mechanism helps David and Linda trust the process when it means selling stocks that are "doing great."

What this means for Jordan

Jordan's aggressive 85/15 allocation still needs rebalancing. If stocks crash 30% and the portfolio drifts to 70/30, threshold rebalancing forces Jordan to sell bonds and buy stocks at depressed prices — exactly the opposite of what panic would dictate. For a 34-year-old with decades ahead, buying stocks after a crash is one of the highest-value actions in all of investing. Rebalancing automates it.

Key takeaways

1. Rebalancing means restoring your portfolio to its target allocation by selling overweight assets and buying underweight ones.
2. Without rebalancing, portfolio drift silently increases your risk far beyond what you intended.
3. Rebalancing systematically sells high and buys low — the opposite of emotional investing.
4. Threshold-based rebalancing (5-point bands) is slightly superior to calendar-based, but either works.
5. Rebalancing controls risk, not returns. The goal is a portfolio you'll hold through the next crash.

Glossary

• Rebalancing — The process of realigning portfolio weights to target allocations by selling overweight assets and buying underweight ones.
• Portfolio drift — The gradual shift in portfolio allocation caused by different asset classes growing at different rates.
• Threshold rebalancing — A rebalancing strategy triggered when any asset class deviates from its target by more than a set amount (e.g., 5 percentage points).
• Calendar rebalancing — A rebalancing strategy executed on a fixed schedule (e.g., quarterly or annually) regardless of drift.
• Risk-adjusted return — A measure of return relative to risk taken, such as the Sharpe ratio. Higher is better.