Rebalancing

Portfolio drift happens naturally as different assets grow at different rates. Consider a simple 60/40 stock/bond portfolio. If stocks return 25% and bonds return 5% over a year, the portfolio drifts to roughly 67/33. You now have significantly more stock market exposure than intended — the portfolio is riskier than your target allocation.

This drift accelerates in trending markets. During the 2020-2021 bull run, a 60/40 portfolio that was not rebalanced could have easily drifted to 75/25 or even 80/20 as tech-heavy stock indices surged. Then when the 2022 bear market hit, those over-allocated portfolios suffered larger drawdowns than intended.

The core problem: portfolio drift systematically increases risk after rallies (when stocks are most expensive and vulnerable) and decreases exposure after crashes (when stocks are cheapest and future returns are highest). Left unchecked, drift causes you to accumulate more of what has been winning and less of what has been losing — the opposite of disciplined investing.

Within a stock portfolio: Drift also applies to individual positions. A concentrated bet that doubles can become 40% of your portfolio even if you only intended 10%. This single-stock concentration creates vulnerability to company-specific risk.

Calendar rebalancing: Rebalance on a fixed schedule — monthly, quarterly, or annually. Simple to implement and requires no daily monitoring. Quarterly is the most common frequency for individual investors. Monthly can increase tax drag from more frequent trading; annually allows significant drift between rebalances.

Threshold rebalancing: Rebalance whenever any asset class drifts beyond a defined tolerance band (typically 5% of target). If your target is 60% stocks and the band is 5%, rebalance when stocks exceed 65% or drop below 55%. This method responds to actual drift rather than arbitrary dates, making it more reactive to volatile markets.

Hybrid approach: Check allocations quarterly but only rebalance if drift exceeds a minimum threshold (e.g., 3%). This avoids unnecessary trading in stable periods while catching significant drift before it compounds.

Cash flow rebalancing: Instead of selling winners, direct new contributions toward underweight asset classes. This avoids triggering capital gains taxes entirely. For investors making regular contributions (401k, IRA), this is often the most tax-efficient rebalancing method.

Band rebalancing: Rather than restoring the exact target weight, rebalance only to the edge of the tolerance band. If stocks drift to 66% with a 60% target and 5% band, sell enough to bring stocks back to 65% rather than all the way to 60%. This reduces trading costs and tax events while still controlling drift.

In taxable accounts, rebalancing creates capital gains when you sell appreciated assets. Several strategies minimize this tax drag:

Use tax-advantaged accounts for rebalancing: Keep volatile, frequently-rebalanced asset classes (stocks, REITs) in tax-deferred accounts (401k, IRA) and stable asset classes (bonds) in taxable accounts. Do most rebalancing inside the tax-advantaged account where gains are not immediately taxed.

Tax-loss harvesting during rebalancing: When rebalancing requires selling losing positions, harvest those losses to offset gains from selling winners. This can make the entire rebalancing event tax-neutral.

Redirect dividends and distributions: Instead of reinvesting dividends within the same fund, direct them to underweight asset classes. This provides ongoing rebalancing without selling anything.

Use specific lot identification: When selling to rebalance, sell the highest-cost tax lots first to minimize realized gains. Most brokers support specific lot identification for tax-optimized selling.

Consider the wash sale rule: If you sell a fund at a loss for tax harvesting and immediately buy a substantially identical fund to maintain allocation, the IRS disallows the loss under the 31-day wash sale rule. Use a similar but not identical fund (e.g., switch from one S&P 500 index fund to another provider's total market fund) during the 31-day window.