How to Rebalance a Portfolio

Wondering how to rebalance your portfolio (and how to avoid paying taxes)? In this article, discover the answers to your rebalancing questions.

Over time, the contents of your portfolio will naturally shift away from your target allocation.

Rebalancing your portfolio aims to get your allocations back to your desired risk level. You simply sell some of the better-performing stocks in your portfolio and buy the stocks that underperformed.

But where do you start? And what will it cost you?

Now that free stock and ETF trades are the norm, rebalancing your portfolio is fairly easy and cost-effective. Learn how to get started, plus the benefits of rebalancing, in this guide.

How do you rebalance a stock portfolio?

Rebalancing your portfolio is relatively easy to do. Some brokers offer automated rebalancing tools, but the process is also easy enough to do on your own with a basic Excel sheet.

Here are the basic 5 steps to rebalance your portfolio:

1. Find the current weight/allocation of each holding (stocks, bonds, mutual funds, options, etc.) in your portfolio.

   Note: Many online investing platforms will have this information easily accessible on your main dashboard.

2. Compare this to your target allocation.

3. Look at the gap between the current and target allocations and apply some tolerance threshold, such as 5%. This represents the maximum deviation that you're willing to tolerate.

   Any position where this deviation exceeds this tolerance is subject to rebalancing.

4. Calculate the number of shares of each position (where the deviation exceeds your threshold) that need to be bought or sold to bring its weight back to your target allocation.

   Remember to also account for any cash flows if you plan to deposit or withdraw money as part of the rebalancing.

5. Carry out the trades you calculated in the previous step.

Keep in mind, this process can take some time with larger portfolios.

How do you rebalance a portfolio without paying taxes?

Any time you sell an investment for a gain, Uncle Sam collects his share. So how can you rebalance your portfolio without incurring any capital gains tax in the process?

There are a couple of ways to do this, detailed below.

1. Use a tax-advantaged brokerage account: If you are rebalancing in a tax-advantaged account, such as a 401(k) or IRA, selling stock won't trigger capital gains tax since this won't become due until you actually withdraw money during retirement.

2. Cash flow rebalancing: If you are rebalancing in a taxable account, you can also avoid taxes by cash flow rebalancing. Instead of selling the stocks to reduce their weights, you could hold on to them and add more cash to the portfolio to increase the weights of the other stocks.

3. Asses long-term vs short-term gains: If you know your rebalancing is going to trigger a tax bill, try to assess whether your capital gains are long-term or short-term.

   Long-term gains are taxed more favorably than short-term gains. So, it may make sense to wait a year to sell any of your high-performing stocks, assuming all else is equal.

How often should you rebalance your portfolio?

While there is no set rule on how often you should rebalance your portfolio, most financial advisors suggest doing it 1-4x yearly.

Most younger investors should be fine to rebalance once yearly, while more seasoned investors with larger portfolios can benefit from rebalancing more often.

The best time to rebalance will depend on your desired approach:

• Rebalancing at a pre-determined date (e.g., each quarter-end)
  
• Rebalancing whenever any of your allocations deviate from your target by a set amount

Compare the pros and cons of each approach below.

Rebalancing on a Pre-set Schedule
Some investors prefer to keep things simple by rebalancing on a pre-determined schedule, such as every quarter or every six months.

• Pros: Easier to plan the timing of any cash flows to/from your portfolio to coincide with the rebalancing
  
• Cons: Big market movements could cause big shifts in your allocations in the interim
  
• Who it's best for: Younger, more hands-off investors who have to rebalance manually (without the help of a brokerage, financial advisor, etc.)

Rules-based rebalancing
Rules-based rebalancing is when you set a pre-determined deviation (current allocation versus target) that you are willing to tolerate in your portfolio, and whenever that tolerance is breached, that triggers a rebalance.

• Pros: More thought-out than arbitrarily deciding to rebalance every quarter
  
• Cons: Harder to plan any cash flows around your rebalancing since the timing is not known in advance
  
• Who it's best for: Seasoned investors who need to adjust their portfolio according to big financial events/goals (saving for a child's college tuition, receiving inheritance, etc.)

How important is rebalancing your portfolio?

When a human or a robo-advisor asks about your investing goals and risk tolerance, they are trying to determine your ideal allocations so you're not taking on more risk than necessary.

As these allocations shift over time, it's important to monitor and rebalance them whenever they deviate too far from your target allocations.

Failing to do this could result in your portfolio being over-exposed (or under-exposed) to certain asset classes, resulting in a risk level that is not appropriate for your investing goals.

Why should you not rebalance your portfolio?

The biggest argument against rebalancing a portfolio is the possibility of incurring high transaction/trading fees. Luckily, this argument is becoming less relevant as more brokers offer free stock and ETF trades.

If your portfolio includes positions that could incur trading costs, such as mutual funds or investments in hedge funds or private real estate, be sure to consider the costs associated with trading those positions and rebalancing those less frequently to avoid the costs.

Other than trading costs, another reason why you might avoid rebalancing is simply to save time. This is especially true if you have a complex portfolio consisting of many positions across many asset classes (and potentially across multiple brokers).

But if your portfolio is large and complex, you should still rebalance it. You might simply choose to do it less frequently given that larger portfolios will generally take longer to rebalance.

Portfolio Rebalancing Tools

Brokers that offer robo-advising generally include automatic rebalancing as part of this service, and we'll cover these in the rest of this article.

The downside is that most robo-advisory platforms are not free. If you don't pay for a robo-advisor, you may still prefer to rebalance your portfolio in Excel.

For those with retirement accounts, note that most employer-based 401(k) platforms include free rebalancing tools that you can take advantage of.

For 401(k) plans, you generally have a limited list of funds to choose from (whether they be Fidelity, Vanguard, or some other fund family), and so this enables the broker to easily offer free rebalancing in these types of accounts.

Fidelity

Fidelity's robo-advisory platform, called Fidelity Go, includes automatic rebalancing.

Fidelity Go will ask you a bunch of questions to understand your risk tolerance and investing goals and then set up your portfolio based on your investor profile.

Their robo-platform invests your money exclusively in Fidelity mutual funds, and so it is easy for them to rebalance your portfolio as frequently as is needed as your exposures change with the market.

The rebalancing itself is free, but Fidelity Go might come with a fee depending on your account balance. Fidelity doesn't charge any fees for accounts under $10K, charges $3/month for balances between $10K and $50K, and an annual fee of 0.35% for accounts over $50K.

The biggest downside to Fidelity Go (and any robo-advisor) is that they only use their own mutual funds. If you want to hold specific stocks in your portfolio, this would be outside of their robo-platform and therefore also not eligible for automatic rebalancing.

Vanguard

Vanguard takes a slightly different approach to rebalancing your portfolio. Instead of rebalancing each account on their platform, they encourage investors to take advantage of their "all-in-one mutual funds."

These are purpose-built mutual funds with their own unique allocations that are geared toward a specific risk/reward profile. The funds are constantly rebalanced to keep them in line with their risk/reward profile.

For example, with Vanguard's target date retirement funds, they have a fund for each year (in 5-year intervals). Instead of buying 5 different funds and adjusting their allocations as they get older, retirees-to-be can just buy a single fund that automatically adjusts as it nears the advertised retirement year.

Similarly, Vanguard offers LifeStrategy Funds with pre-established risk levels and allocations for everyday investors to choose from that are automatically rebalanced to their target allocations as needed.

Charles Schwab

Similar to Fidelity Go, Schwab offers a robo-advisory platform called Schwab Intelligent Portfolios, which includes automatic rebalancing.

Schwab's robo-platform is nice in that it is entirely free to use, and the only expenses you'll pay are the expense ratios of the ETFs they invest your money in.

Similar to how Fidelity Go uses Fidelity mutual funds, Schwab allocates your portfolio mostly across their own family of ETFs, so this may impact your choice of robo-advisor if you have a preference for one over the other.

DIY Rebalancing in Excel

And last but certainly not least is Microsoft Excel. We should never discount the versatility and ease of use of an Excel spreadsheet, which is as useful for portfolio rebalancing as much as it is for any other rules-based calculations.

And assuming you already have access to Microsoft Excel, it won't cost you anything.

The calculations needed to rebalance your portfolio are basic math, and so creating an Excel template to rebalance your portfolio with it should be easy. That said, there are plenty of personal finance blogs where users have shared their own Excel templates for others to use.

Bottom Line

While rebalancing your portfolio doesn't necessarily lead to better returns, it does make sure your exposures stay within your desired risk level and your portfolio remains on track to meet your investment goals.

Your frequency and desired method of rebalancing is entirely up to you. What's most important is that you do make rebalancing part of your portfolio's routine checkup.