Rebalancing: How Restoring Target Weights Works, Calendar Versus Band Methods

Weights drift on their own

If you set weights such as 60% stocks and 40% bonds and leave them alone, the weight of whatever rose most grows over time, because its value rises while the others fall behind in relative terms. A portfolio that started at the risk level you intended can, a few years later, be far more aggressive, and if the asset that rose most then turns down, the hit is bigger than planned. The figure below shows how the stock weight moved in an example period when stocks rose faster than bonds. Left alone, a stock weight that started at 60% ended above 80% after five years; rebalanced only when it left a 55 to 65% range, it was reset four times and stayed inside that range.

What rebalancing does and does not do

Rebalancing means selling part of the assets that grew beyond target and buying those that shrank, so the weights return to plan. In effect you trim what rose and top up what fell, but thinking of it as a 'buy low, sell high technique' leads to misunderstanding. Its main purpose is to keep the risk level you chose. In periods when one asset rises steadily for a long time, you keep trimming it, so returns are often lower than if you had left it alone. In periods when assets go up and down repeatedly, rebalancing can add to results. Since you cannot know in advance which will happen, rebalancing is better seen as a way to keep a portfolio's character as planned than as a device that guarantees returns.

Calendar method: rebalance on set dates

The simplest approach is to check weights on set dates, such as every quarter, every six months or once a year, and bring them back to target. The rule is simple, easy to follow and leaves little room for emotion. But you may end up making small trades because it is the scheduled day even though weights barely moved, or, conversely, wait until the next check while the market has moved a lot and weights are far off. Shorter intervals keep weights closer to target but increase trades and costs. There is no single right interval; choose one by weighing costs and effort.

Band method: rebalance only when outside the range

The band method sets an allowed range around each target weight and rebalances only when a weight leaves it. There are two main ways to set the range. An absolute band is set in percentage points, such as ±5 points around a 60% target, giving a range of 55 to 65%. A relative band is set as a fraction of the target; for example, a relative 25% on an asset with a 20% target gives 15 to 25%. For small positions an absolute band can be too wide or too narrow, so relative bands are sometimes used alongside. Narrow bands mean frequent rebalancing; wide bands mean rare rebalancing. In practice many people combine the two: check on set dates but trade only if a weight is outside its band.

• Absolute band: target ± some points (example: 60% ± 5 points → 55 to 65%)
• Relative band: target × some percent (example: 20% × 25% → 15 to 25%)
• Combined: check on set dates and trade only when outside the band

How to rebalance

There are several ways to bring weights back. The basic way is to sell what grew and buy what shrank, but if you are adding new money you can buy only the underweight asset to restore balance. Since nothing is sold, no selling costs or taxes arise. Putting dividends or interest into the underweight side works on the same principle. You also need to decide whether to go all the way back to target or only to the edge of the band. Stopping at the edge reduces the amount traded but makes it easier to drift out again. Whatever method you use, writing it down as a rule in advance matters. Without a rule, thoughts like 'it looks like it will rise a bit more, so let it run this time' creep in and rebalancing turns into market forecasting.

Costs and taxes

Rebalancing involves trading, so it costs money: brokerage fees and bid-ask spreads, the securities transaction tax when selling Korean stocks, capital gains tax on profits from selling foreign stocks, and currency conversion costs. Accumulated, these can exceed whatever rebalancing was meant to achieve, so the more often you rebalance, the more carefully you should count costs. Taxation also depends on the type of account, so trades inside a tax-deferred account can have a different net benefit from trades in a regular account. Tax rates and allowances change with reforms, so see the guides on taxes on stock investing and on how frequent trading leaks money, and if the amounts are large, confirm current rules with official guidance.

Using the tools on this site

In this site's Stock Compare, pick up to five of your holdings and look at their cumulative returns over the same period to work out how far your weights have drifted. An asset with starting weight w and subsequent return r now has a weight of w × (1 + r) divided by the sum of the same value for all assets. The correlation and annual volatility on the same screen help you gauge which assets will push weights around fastest. Stock Paper Trading has no automatic rebalancing, but with its virtual won and dollar accounts you can make the trades to restore weights yourself and see how much fees and the Korean selling tax cost. The principles of correlation and diversification are in the guide on diversification and correlation.

Rebalancing rule checklist

When setting a rebalancing rule, write down the items below in advance. Rules are easiest to keep when they are set while markets are calm. In the middle of a big decline, buying more of the falling asset is psychologically hardest, and in the middle of a big rally, trimming the rising asset is hardest.

• Target weight for each asset
• Trigger: calendar, band, or a combination
• How far to rebalance: to target or to the band edge
• How to rebalance: selling and buying, or using new money and dividends
• Minimum trade size given trading costs and taxes
• When to review the rule itself

Limits and disclaimer

The figure in this guide uses randomly generated example prices to show the principle; it is not a record of real assets. Rebalancing results depend on the period, assets, rule, costs and taxes, and no rule can be said to be always better. Tax rules can change, so check current rules before actual trades. This guide explains the principles and methods of rebalancing, does not recommend any particular weights or trades and is not investment advice.