Rebalancing rules

In short

A friend of mine once said his portfolio was like a garden he had stopped weeding. You have probably felt that pull too, the sense that things drift while you look away. Rebalancing is the plain act of bringing your mix of investments back to the split you chose. You can do it on a set date, or when a holding strays past a set gap from its target. Write your rule down before the market gets loud, so your feelings do not make the call. Check whether the account is taxable, because selling there can create a tax bill. Costs matter too, so look at trading fees and fund fees first.

The whole of it

What it is

I once watched an old farmer walk his fence line every spring, and he never skipped it. He did not wait for the cows to wander off before he checked the posts. Rebalancing works the same way. If you are holding a mix of stocks and bonds, the mix will not stay put on its own. Stocks may grow faster in one season, and then they take up a bigger slice than you planned. Your plan said sixty percent stocks, but the pie now shows seventy. That is drift.

Rebalancing means moving the pie back toward the plan. You sell a little of what grew too big, or you send new money to what grew too small, or both. The goal is not to beat the market. The goal is to keep your risk where you meant it to be. A portfolio that has drifted is a different portfolio than the one you agreed to carry. You may not even notice until a rough year shows you how much more you owned of the bumpy stuff.

I want to say something kind here. If you have never rebalanced, you are not behind. Many of us start by picking funds and then forgetting them. Setting a rule now is a fine place to begin.

How it works

A neighbor of mine keeps a calendar reminder for the first day of each year. That is one way to do it, and it is called calendar rebalancing. You pick a date, look at your split, and move things back to target. Some people choose once a year. Others choose twice. The date itself matters less than sticking to it.

The other way uses a band, sometimes called threshold rebalancing. You pick a gap, say five percentage points, and you act only when a holding strays past it. If your target for stocks is 60 percent and it climbs to 65 or beyond, you rebalance. If it sits at 63, you leave it alone. Some people mix the two. They check on a set date, but they only trade if a band was crossed.

You also have three tools for the job. You can sell the overgrown holding and buy the shrunken one. You can direct new deposits, or dividends, toward whatever sits below target. Or you can change how your future contributions are split. The second and third tools often cost less, because you avoid selling and you avoid the tax that can come with it.

Neither method is right for everyone. A calendar is easy to follow. A band reacts to real moves but asks you to watch more often. Each one has a price in time or attention. The choice is yours.

The numbers, and where to find yours

If you are holding funds today, you probably want to know which numbers matter. Start with your target split, which is the mix you chose. Then find your current split, which your account page shows, often as a pie chart or a list of percentages.

Next comes the band. That is the gap you allow before acting, and it is your choice. Then look at taxes. If you sell in a taxable account, you may owe tax on the gain. The IRS explains this in Publication 550, Investment Income and Expenses, and in Topic No. 409 on capital gains and losses. The long term capital gains rates are set by law and change over time, so the rate for a given year is the current figure, which the official source publishes each year. The holding period that decides whether a gain counts as long term is the current figure, which the official source publishes each year.

Inside a tax deferred account like a 401(k) or a traditional IRA, selling to rebalance does not trigger tax on that trade. The same goes for a Roth IRA. The yearly contribution limit for an IRA is the current figure, which the official source publishes each year, and for a 401(k) it is the current figure, which the official source publishes each year. Those limits matter because new deposits are one of the lowest cost rebalancing tools.

Last, check costs. Look at any trading fee your broker charges and at each fund's expense ratio, which is the yearly fee taken from the fund. You can find the expense ratio in the fund's prospectus, the document every fund must provide. The SEC's investor education site, Investor.gov, explains how to read one.

A worked example

Let me tell you about Marcus, a teacher who earns 52,000 dollars a year. He saves in a 401(k), and his school adds a match of 3 percent. His target is 60 percent stocks and 40 percent bonds.

Marcus has 50,000 dollars in the account. A good stretch for stocks leaves him with 33,000 dollars in stocks and 17,000 dollars in bonds. We can check his split. Stocks are 33,000 divided by 50,000, which is 0.66, or 66 percent. Bonds are 17,000 divided by 50,000, which is 0.34, or 34 percent. He set a band of five points, so 60 plus 5 is 65. At 66 percent, he has crossed it.

Now he needs to know how much to move. His target for stocks is 60 percent of 50,000, which is 30,000 dollars. He holds 33,000, so he is over by 3,000 dollars. Bonds should be 40 percent of 50,000, which is 20,000 dollars. He holds 17,000, so he is short by 3,000 dollars.

Marcus could sell 3,000 dollars of stocks and buy 3,000 dollars of bonds. That is inside a 401(k), so no tax comes from the trade. After it, he holds 30,000 in stocks and 20,000 in bonds, which is back to 60 and 40.

But Marcus likes a gentler way. Say he puts 6 percent of his pay into the plan. That is 52,000 times 0.06, which is 3,120 dollars a year of his own money. The 3 percent match adds 52,000 times 0.03, which is 1,560 dollars. That totals 4,680 dollars a year. If he points all of it toward bonds, it takes him most of a year to close a 3,000 dollar gap. He can do that instead of selling. Either path works. He picked the one that felt calmer.

Where it goes wrong

I have made this mistake myself, so I say it kindly. The first trap is doing it too often. Every trade can carry a fee, and in a taxable account, every sale can carry a tax bill. Checking daily and trading on every wiggle can cost you more than the drift would.

The second trap is skipping it when it feels bad. After stocks have fallen, selling bonds to buy stocks feels wrong. After stocks have soared, selling some feels like walking away from a party. The rule exists for exactly those moments. Feelings pull one way, and the plan pulls another.

The third trap is forgetting the tax side. A friend of mine rebalanced a taxable account in a big year and got a bill he did not see coming. He felt foolish, but he did not need to. It is easy to miss. Look at where each holding sits before you sell it.

The fourth is treating the band as a promise of profit. Rebalancing is a way to manage risk. It is not a source of extra return. Over some stretches it may trail a portfolio left alone, and over others it may do better. No one knows which.

The last trap is a rule too tangled to follow. Each added trigger or exception is one more thing to remember. A plan with many parts can be hard to carry out when the market is loud.

Questions to answer before you leave this page

What split did you choose, and did you write it down somewhere you will find it again? Will you check on a set date, or only when a holding crosses a band, and how wide will that band be? Which of your accounts are taxable, and which are tax deferred, so you know where a sale might cost you? Could new deposits or dividends do the work instead of selling? What do the trading fees and fund expense ratios come to on the moves you have in mind? And when the market gets loud and your stomach tightens, what one sentence from your own rule will you read to yourself first?