What you will learn
- Explain why an allocation drifts over time
- Compute how weights change after assets move
- Understand rebalancing as risk control and forced discipline
- Weigh calendar versus threshold methods and their costs
You chose a target allocation last lesson. The catch is that it will not stay put. As your assets rise and fall at different rates, the mix drifts away from your target, quietly raising or lowering your risk without your ever deciding to. Rebalancing is the habit of pulling it back, and it is one of the simplest and most useful routines in portfolio management.
Portfolio rebalancing explained (Ryan O'Connell)
Covers what rebalancing is, when to do it, and how it controls risk. Good overview for this lesson.
Why allocations drift
Say you set a target of 60 percent stocks and 40 percent bonds. Over a year when stocks surge and bonds are flat, the stock slice grows to a bigger share of the total, simply because the winners now make up more of the pie. Your portfolio has drifted to a riskier allocation than you chose, without any decision on your part. This drift is the natural result of holding assets that perform differently, and left alone it pushes your portfolio toward whatever has recently run up, increasing risk exactly when valuations are highest.
Measuring the drift
You start with 6,000 dollars in stocks and 4,000 in bonds, a 60/40 split of a 10,000 dollar portfolio. Over the year stocks rise 50 percent while bonds stay flat. What is the new stock weight?
- New stock value. 6,000 grown by 50 percent is 6,000 plus 3,000, which is 9,000 dollars.
- New total. 9,000 in stocks plus 4,000 in bonds is 13,000 dollars.
- New stock weight. 9,000 divided by 13,000 is about 0.692, or 69.2 percent.
Why it matters: Without buying a single share, your portfolio is now far riskier than the 60/40 you chose. Rebalancing would sell stocks and buy bonds to restore the target.
How much to sell
Continuing the example, the portfolio is worth 13,000 dollars and you want stocks back at their 60 percent target. Your target stock value is 60 percent of 13,000. You currently hold 9,000 in stocks. How many dollars of stock must you sell?
Rebalancing is risk control, and forced discipline
The main purpose of rebalancing is risk control: it keeps the portfolio at the risk level you deliberately chose rather than letting it drift somewhere you never intended. But it has a second benefit. Because it requires selling what has risen and buying what has lagged, rebalancing enforces a buy-low, sell-high discipline automatically. That runs against the emotional urge to pile into whatever has been hot, the performance-chasing you will study in the behavioral lesson. A mechanical rule imposes the discipline that human psychology fights.
Key terms
- Drift
- The gradual movement of a portfolio's weights away from target as assets perform differently.
- Calendar rebalancing
- Restoring the target at fixed intervals, such as quarterly or annually.
- Threshold rebalancing
- Restoring the target only when a weight drifts beyond a set band, like 5 percentage points.
Rebalancing quietly forces you to sell what has soared and buy what has lagged, the discipline your emotions will always fight.
Portfolio rebalancing: what, when, why, and how (Optimized Portfolio)
Compares calendar and threshold methods and discusses costs. Watch for the tradeoff between discipline and trading costs.
Two methods, and the cost tradeoff
- Calendar rebalancing restores the target at fixed intervals, such as annually, regardless of how far things have drifted. It is simple and predictable.
- Threshold rebalancing restores the target only when a weight drifts beyond a set band, for example more than 5 percentage points. It responds to actual drift, trading more in volatile times and less in calm ones.
Rebalancing is not free. Trading incurs costs, and in taxable accounts selling winners can trigger taxes, both of which drag on returns. Rebalancing too often can cost more than it is worth. The sensible path balances the discipline of holding your target against the drag of costs and taxes: rebalance enough to control risk, but not so obsessively that fees eat the benefit. At its core, rebalancing is a risk-management habit that keeps your portfolio aligned with the risk you chose.
What does rebalancing force you to do?
After a year in which tech stocks soared and bonds lagged, rebalancing your drifted portfolio back to target requires you to...
Rebalancing sells the appreciated tech stocks that grew beyond their target weight and buys the lagging bonds, restoring the chosen mix. This enforces selling high and buying low.Why rebalance at all?
In your own words, explain why letting a portfolio drift without rebalancing is risky, even if the drifting assets are doing well.
Write an answer before comparing it with the model response.
Model answer
When some assets outperform, they grow to a larger share of the portfolio, so the portfolio steadily takes on more of whatever has recently run up. That raises the overall risk above the level I deliberately chose, and it concentrates me in assets that are now more expensive, right when a reversal would hurt most. Even though the drift happens because those assets did well, it leaves me more exposed to them than I intended. Rebalancing pulls the weights back to target, keeping risk where I want it and forcing me to trim winners and add to laggards instead of chasing performance.
Rebalancing keeps your overall mix in line. But within that mix, how much should ride on any single position? That is position sizing, the next lesson, and it is a matter of survival.