Portfolio Rebalancing: Why, When and How

A carefully built portfolio does not stay as you built it. Without any decision on your part, markets change the split between your holdings: those that rise take up more room, those that fall lose some. Rebalancing is the process of bringing that split back toward its target. This article explains why drift happens, the two main methods (calendar and threshold), the associated costs and a worked example. The amounts are fictional and illustrative: they explain a mechanism and are neither a forecast nor a recommendation.

Allocation Drift: A Mechanical Phenomenon

Take a fictional €10,000 portfolio split 60% stocks (€6,000) and 40% bonds (€4,000). This is the target allocation. After a year, stocks have gained 20% and bonds are unchanged:

	Start	End of year	Final weight
Stocks	€6,000	€7,200	≈ 64.3%
Bonds	€4,000	€4,000	≈ 35.7%
Total	€10,000	€11,200	100%

No order was placed, yet the portfolio has become more exposed to stocks than intended: 64.3% instead of 60%. If the trend continues for several years, the drift widens. This is the allocation gap.

The drift is not neutral, because it changes the level of risk actually carried. A portfolio designed for 60% stocks that now holds 75% will swing more than it was meant to. Rebalancing is therefore less about "optimizing" return than about keeping the chosen risk profile. The lesson Asset allocation covers this notion of a target in detail.

Why Rebalance?

Three reasons are commonly given:

Controlling risk. The weight of the most volatile asset classes tends to grow when they rise, which raises the share of risk without anyone having decided it.
Following a discipline. A rule set in advance limits decisions made under the influence of emotion, such as chasing what has just risen or fleeing what has just fallen.
Keeping the intended diversification. A holding that has become very dominant weakens the protective effect of the split. Our article on over-diversification covers the opposite balance.

Precision is needed, though: nothing guarantees that rebalancing improves return. In a continuously rising market, not rebalancing would mechanically have produced more gains, but with more risk. Past performance does not predict future results, and the effect of rebalancing depends entirely on the path markets take.

Two Rebalancing Methods

Method 1: Calendar Rebalancing

You rebalance at fixed intervals: once a year, every 6 months or every quarter, whatever the current situation.

Advantages:

a simple rule, easy to follow;
little monitoring required;
a limited, predictable number of transactions.

Drawbacks:

a large drift can build up between two dates;
on the scheduled date there may be nothing to correct, and the operation then makes no sense.

The higher the frequency, the more transactions and costs pile up, while the gap being corrected often remains small.

Method 2: Threshold Rebalancing

You set a tolerance around the target and act only when it is crossed. Two formulations exist:

Absolute threshold: for example 5 percentage points. For a 60% target, you act if the weight leaves the 55%–65% band.
Relative threshold: for example 25% of the target. For a 10% target holding, you act if its weight leaves 7.5%–12.5%. This formulation suits small holdings better.

In our example, with an absolute threshold of 5 points, the 64.3% weight stays inside the band: no action is triggered. With a 3-point threshold, the 63% limit is crossed.

Advantages: action happens when it is useful and not otherwise, which reduces unnecessary transactions. Drawbacks: weights must be monitored regularly, and the choice of threshold is arbitrary. Too tight and it triggers too often; too wide and it lets drift build up.

A mixed approach, common in practice, is to check on a fixed date and act only if the threshold is breached.

Worked Example: Bringing the Portfolio Back to Target

Back to our fictional portfolio, now worth €11,200. The 60/40 target corresponds to €6,720 in stocks and €4,480 in bonds. To get there:

the stock position goes from €7,200 to €6,720, meaning €480 of stocks reallocated;
the bond position goes from €4,000 to €4,480, meaning €480 added to bonds.

The mechanism also works the other way. Suppose stocks had fallen 25% instead of rising: they are now worth €4,500, bonds €4,000, for €8,500 in total and a stock weight of ≈ 52.9%. The target would be €5,100 in stocks and €3,400 in bonds: rebalancing would mean moving €600 toward stocks. The rule always rebalances against the recent trend, which can be psychologically uncomfortable.

There is a variant that involves no selling: new contributions are directed to the underweight holdings. This limits transactions, and therefore costs, but only works if contributions are large enough relative to the portfolio.

The Costs to Consider

Rebalancing is not free. Several items come into play:

Brokerage fees: if each order costs €1 (an illustrative value), rebalancing 4 holdings generates about €4. That is not much in absolute terms, but proportionally heavy on a small portfolio.
Bid-ask spreads on thinly traded securities.
Possible tax consequences when selling, depending on the account type used. This depends on each person's situation and is outside the scope of this article; check with your provider or a professional.

This is why people generally avoid rebalancing for very small gaps: the cost of the operation can exceed the benefit sought. The lesson Rebalancing offers a complementary framework for weighing this.

Tracking Your Drift in Practice

Rebalancing starts with measuring. You need to know the current weight of each holding, each sector and each region. The diversification score tool (built around the French PEA equity savings plan, but usable as a model for any equity portfolio) gives a descriptive reading of a portfolio's concentration, and the article Analyzing your portfolio's allocation explains how to read these indicators. Earnnest describes the situation without telling you what to do: the decision is yours.

Key Takeaways

Allocation drift is mechanical: with no transactions at all, weights move with markets and the real level of risk changes.
Two main methods: calendar (fixed dates) and threshold (tolerance around the target), often combined.
Rebalancing is above all about keeping a risk profile, not guaranteeing a better return.
Costs (brokerage, price spreads, possible tax consequences) matter: a tiny gap does not always justify a trade.
Directing new contributions to underweight holdings allows rebalancing without selling.

This article is for informational and educational purposes only and does not constitute personalized investment advice.