How Rebalancing Keeps a Portfolio on Track

Rebalancing means trading a portfolio back to its target mix after market moves have pushed it away. Its job is to hold risk near the level you chose, not to raise returns. The main choices are when to do it (on a schedule, when drift passes a limit, or both) and how (selling, or steering new money where it is needed).

Key takeaways

• Drift happens because assets grow at different rates; in the SEC's example, a 60% stock holding can rise to 80% through market gains alone, which changes the portfolio's risk.
• Vanguard research suggests checking annually or semiannually and rebalancing at 5% thresholds for most diversified stock and bond portfolios, and found little difference in risk-adjusted results between frequencies while costs rose with more trades.
• In the illustrative 2000-2025 simulation below, an unrebalanced 60/40 mix ended at 80.7% stocks, while annual and 5-point-band rules ended near 62%; the return differences were small (6.77% to 7.03% a year).
• New contributions, dividends and withdrawals can do much of the rebalancing without a sale, and sales inside a traditional IRA are generally not taxed until money is withdrawn.

Why portfolios drift off target

The SEC's investor education site explains that over time some investments grow faster than others, which can push holdings out of line with your goals and change the portfolio's risk level. Its example is a portfolio that starts with 60% in stocks and sees that rise to 80% after market gains; restoring the original mix may take selling some stocks, investing more in other categories, or both.

Drift is simple arithmetic. A weight is an asset's value divided by the portfolio total, so whichever holding earns more takes a bigger share of the total, and the portfolio's risk shifts toward it. Nobody has to make a decision for it to happen, which is why an unattended portfolio tends to become more aggressive after a long stock rally and more conservative after a long decline.

A $100,000 drift example

Illustrative example (hypothetical numbers, no taxes or trading costs). A portfolio starts at $100,000: $60,000 in stocks and $40,000 in bonds. In one year stocks rise 25% and bonds fall 5%.

Selling restores 60/40 with one trade pair: sell $7,200 of stocks ($75,000 minus $67,800) and buy $7,200 of bonds. The $10,000 contribution gets within about one point of target without any sale, but not all the way: stocks are already $75,000, so a $123,000 portfolio at 60% would need only $73,800 in stocks. Reaching exactly 60% by contribution alone would take a $12,000 deposit ($75,000 divided by 0.60 is $125,000, minus the $113,000 already there).

Taxes enter if the sale happens in a taxable account. If, hypothetically, the stock holding had cost $60,000, one-fifth of the holding's value would be gain: selling $7,200 would realize $1,440 of gain ($7,200 × ($15,000 ÷ $75,000)), with the tax rate depending on how long the shares were held. The same $7,200 trade inside an IRA would trigger no capital gains tax. To test your own weights and deposits, use the rebalancing calculator.

Weight = asset value / portfolio total
Trade needed = current asset value - (target weight x portfolio total)
Positive result: sell that amount. Negative result: buy that amount.

Calendar, threshold, hybrid rules

There are three common ways to decide when to act. Vanguard's investor guidance describes them as calendar-based (reset on a fixed schedule), threshold-based (act only when an allocation strays far enough, which requires regular monitoring), and a combination in which you check on a calendar and rebalance only if assets have strayed by more than a set percentage. Its worked example uses a 70/30 target and acts when the allocation is off by 5 percentage points or more.

The SEC's Investor.gov notes the same split: some experts rebalance at regular intervals such as every six or 12 months, others when a holding moves more than a pre-set percentage, and in either case rebalancing tends to work best when done relatively infrequently.

The 5-point band and the 6- or 12-month schedule are conventions, not rules. Vanguard's research, summarized in an AAII Journal article by Vanguard authors (May 2011, US data from 1926 through 2009), recommends annual or semiannual monitoring with rebalancing at 5% thresholds for most broadly diversified stock and bond fund portfolios, and says annual rebalancing may be preferred when taxes or substantial time and costs are involved. The same article found only small differences in return and volatility across settings, but large differences in activity: monitoring monthly with a 1% threshold produced 389 rebalancing events, while monitoring annually with a 10% threshold produced 15. Its conclusions assume future returns resemble historical US stock and bond behavior.

Rebalancing without a big tax bill

Use cash flows before sales

Investor.gov's 2012 bulletin on year-end investing lists three ways to rebalance: sell over-weighted assets and buy under-weighted ones; buy more of the under-weighted assets; or, if you contribute regularly, send more of each contribution to the under-weighted categories until the mix recovers. Vanguard adds two cash-flow tools: point dividends and interest at underweighted asset classes, and when withdrawing, start with the overweighted classes. The $10,000 deposit above is the first method at work.

Trade where gains are not taxed now

The IRS says amounts in a traditional IRA, including earnings and gains, are generally not taxed until you take a distribution. That makes a traditional IRA the cheaper place to sell when it holds the overweight asset, leaving taxable holdings untouched. The tax on later withdrawals is a separate question.

Know the holding period

In a taxable account, IRS Topic no. 409 says assets held more than one year produce long-term gains or losses, and assets held one year or less produce short-term ones. Net short-term gains are taxed as ordinary income at graduated rates. Most net capital gain is taxed at 0%, 15% or 20% depending on taxable income, with a few categories taxed at up to 25% or 28%, and people with significant investment income may also owe the net investment income tax. Two choices change the bill. Selling shares with a higher cost basis, which Vanguard's guidance suggests for taxable accounts, lowers the gain realized per dollar sold. Selling lots held more than one year doesn't shrink the gain, but it gets the long-term rates. Vanguard also suggests partial rebalancing: move only part of the way back to target, or trade only the asset classes that are far off, to limit both taxes and transaction costs.

Losses and costs

Selling an overweight holding that is at a loss can offset gains elsewhere, but under the wash sale rule in IRS Publication 550 the loss is disallowed if you buy substantially identical securities within 30 days before or after the sale, including in an IRA or Roth IRA. Usually the disallowed loss is added to the basis of the new shares, so it is postponed rather than lost, but that adjustment does not apply when the repurchase is made in an IRA or Roth IRA. Beyond taxes, the AAII article by Vanguard's researchers lists transaction costs, such as commissions and fund fees, and the investor's own time and labor as costs of rebalancing, so each extra trade has a price.

What the 2000-2025 data show

To see what rebalancing changes, the simulation below uses Aswath Damodaran's historical returns file (S&P 500 including dividends, and the 10-year US Treasury bond return, annual, through 2025). It starts at 60/40, applies each calendar year's returns, and tests three rules at each year-end: never rebalance, rebalance every year, and rebalance only if the stock weight is more than 5 percentage points from 60%. There are no taxes or trading costs.

Over 2000-2025 the rebalanced mixes earned slightly more, 0.17 and 0.26 percentage points a year, but the result is specific to the period. Stocks fell in 2000-2002 and 2008, so rebalancing bought stocks at lower prices. The never-rebalanced portfolio sat below 60% stocks at every year-end from 2000 through 2016, as low as 34.4% at the end of 2008, which is why its measured volatility is lowest here. It also finished at 80.7% stocks, so its risk going forward is higher than where it started. The -18.0% was 2022 in all three, when both stocks (-18.0%) and bonds (-17.8%) fell.

A different start date reverses the return ranking.

Here the portfolio left alone reached 79.5% stocks by the end of 1999 and 91.5% by the end of 2025. It earned more over the 36 years, but with 1.7 to 1.9 points more annual volatility and a deeper drawdown (-21.2% from the end of 1999 to the end of 2002). Together the two runs show what rebalancing reliably does and what it does not. It kept risk close to the 60/40 target in both periods; whether it added or cost return depended on which asset led. That matches Vanguard's stated aim, which the AAII article summarizes as minimizing risk relative to a target allocation rather than maximizing returns.

Limits of this test: annual returns hide drawdowns inside the year, so a rebalance after a mid-year plunge is not modeled; the 5-point band is checked only at year-end and every trade resets fully to 60/40; a 10-year Treasury series stands in for all bonds; and a single historical path says nothing about future results.

Frequently asked questions

Do target-date funds rebalance on their own?

Inside the fund, yes. The SEC's target date funds bulletin (March 25, 2025) says these funds rebalance or change their mix over time, typically becoming more conservative as the target date nears. It also says funds with the same date can differ in strategy, glide path and fees, and that those structured as mutual funds or ETFs do not guarantee retirement income. The bulletin covers only mutual fund and ETF versions, not collective investment trusts. The fund rebalances only its own holdings, so any other investments held alongside it still drift.

Should I rebalance after every big market move?

Investor.gov says rebalancing tends to work best when done relatively infrequently, and Vanguard's guidance says its research found monthly or quarterly calendar rebalancing too frequent and rebalancing only every two years too infrequent, with an annual rebalance optimal for many investors. The AAII-published study found that tighter monitoring tracked the target more closely but made only relatively insignificant differences in return and volatility.

How do I rebalance while taking withdrawals?

Vanguard suggests drawing first from the overweighted asset classes, which moves the mix back toward target without buying anything. If you must take required minimum distributions, Vanguard also suggests taking them while you rebalance and reinvesting them in an underweighted asset class in a taxable account. The IRS says RMDs generally start at age 73 and do not apply to Roth IRAs while the owner is alive. The final Treasury regulations set the starting age at 75 for people born in 1960 or later.

Does the wash sale rule apply to ordinary rebalancing?

Only when a sale produces a loss. Publication 550 describes a wash sale as selling at a loss and buying substantially identical securities within 30 days before or after, and it also counts purchases by a spouse or a corporation you control. Selling an overweight holding at a gain is not covered, because the rule disallows losses only. If you sell a fund at a loss, buying the same fund back within 30 days, even as part of a later rebalancing trade, triggers the rule.

Is a 5% threshold the same as 5 percentage points?

Not necessarily, so it is worth writing down which one you mean. Vanguard's investor page example acts when an allocation is off target by 5 percentage points or more, and that is the reading used in the simulation above. The AAII article describes thresholds only as a "predetermined minimum percentage, such as 1%, 5%, 10% and so on." Read as a share of the target weight instead, 5% of a 60% stock target is just 3 points (57% to 63%). That band would trigger trades much more often than a 5-point band (55% to 65%).

A short rebalancing checklist

1. Write down the target mix and the band you will act on, for example a check once a year and a trade only if a weight is 5 points off.
2. At each check, compute current weights across all accounts together, using the formula above.
3. If rebalancing is due, first direct new contributions and dividends to the underweight asset; if withdrawing, draw from the overweight one.
4. If selling is still needed, do it in a traditional IRA or other tax-deferred account first, then in taxable lots with a higher cost basis or held over one year, and check the 30-day wash sale window before selling at a loss.
5. Compare the trade size with its cost in spreads, commissions and tax before placing it, and skip trades that are tiny relative to the drift.

Sources

• Investor.gov (SEC): Asset Allocation and Diversification
• SEC and FINRA: Investor Bulletin, Year-End Investment Considerations for Individual Investors (Dec. 6, 2012)
• SEC Office of Investor Education and Assistance: Target Date Funds, Investor Bulletin (March 25, 2025)
• Vanguard: Rebalancing your portfolio
• AAII Journal (May 2011): Best Practices for Portfolio Rebalancing, by Jaconetti, Zilbering and Kinniry
• IRS: Topic no. 409, Capital gains and losses
• IRS: Publication 550, Investment Income and Expenses (wash sales)
• IRS: Traditional IRAs
• IRS: Retirement topics, Required minimum distributions (RMDs)
• Federal Register: Required Minimum Distributions, final regulations (July 19, 2024)
• Aswath Damodaran (NYU Stern): Historical returns on stocks, bonds and bills, 1928-2025