How to rebalance your portfolio

Portfolio rebalancing is the process of keeping the original asset mix or proportions within a portfolio the same over time. Rebalancing is seen as important because it keeps the portfolio at the desired risk level and asset allocation​. This stability allows for long-term goal planning.

Portfolio rebalancing brings a collection of investments back to its intended or updated configuration. This is required because asset prices rise and fall over time, resulting in those assets becoming a smaller or larger part of the overall portfolio. As this happens, the portfolio deviates from the originally selected portfolio allocation and risk tolerance.

For example, assume an investor has a £50,000 portfolio, and they invest half in stocks and half in bonds, and they want to maintain this ratio over time. Assume the stocks increase by 20% in a year and bonds increase by 3%. The stocks are now worth £30,000, and the bonds are worth £25,750, making the portfolio valued at £55,750. And stocks now represent almost 54% of that.

Over time, if this trend were to continue, stocks would continue to account for more and more of the portfolio value. This is not the original goal of the portfolio, so to rebalance it back to 50/50, the investor could sell some stock and buy more bonds.

Without rebalancing, a portfolio will change over time and no longer have the asset allocation, risk tolerance, or return potential initially decided upon. Here are some reasons why rebalancing is important:

By not rebalancing, the benefits mentioned above are reduced or eradicated.

Consider a stock investor who has a portfolio of stocks, with 5% of their capital allocated to each stock. Assume that over multiple years, one stock does very well, performing better than the other stocks in the portfolio. Over the course of five years, that stock now accounts for 30% of the total portfolio.

While this may seem good because the stock went up, the portfolio is steadily becoming riskier and more concentrated in one stock. If that stock were to crash, it could jeopardise retirement plans or long-term goals. This is called being overweight in the portfolio. The portfolio has overexposure to one stock. By comparison, the other stocks in the portfolio are underweight. The allocation for each stock, and risk tolerance of the whole portfolio, is no longer what it was originally designed to be.

This is why portfolio diversification​ is important.

There are several ways for investors to rebalance their portfolios. Each method or strategy has the same goal of keeping the portfolio aligned with the investor’s goals and risk tolerance.

There is no definitive answer on when to rebalance. Some investors rebalance once per year, some rebalance quarterly, while others rebalance only when the portfolio deviates from the original portfolio allocation by a certain amount or percentage.

Rebalancing isn’t always required. Therefore, some investors would look at their portfolio at least once per year to assess whether it has diverged enough to warrant rebalancing. A 5%, and especially a 10% or more, divergence is where it may become significant, according to investment advisor The Vanguard Group.

For example, if you said you would hold 50% of the portfolio in stocks, and it is now at 60% of the portfolio, some investors may consider rebalancing in this case to remain under the 5-10% divergence.

Rebalancing has costs associated with it (as discussed below), so rebalancing when it isn’t required may be a waste of money.

Rebalancing a portfolio requires selling some assets to buy others. This can incur commissions fees.

If the portfolio is not inside a spread betting account or other type of tax-protected account, sales of assets may be subject to capital gains tax. If the money needed to pay the capital gains tax is taken out of the portfolio, this reduces the compounding effect and amount of capital in the account. Learn more about spread betting​ with us, which is tax-free in the UK and Ireland*.

Traders should take costs into account when choosing how often to rebalance. Rebalancing too often can increase costs and reduce overall returns.

Yes, there are portfolios that automatically rebalance. Exchange-traded funds (ETFs) automatically rebalance.

We offer a number of exclusive share baskets, a CFD product consisting of a basket of stocks, whose portfolios are automatically rebalanced. For example, our RRG Momentum+ share baskets​​ are created by us in collaboration with the founders of RRG Research and are based on holding a revolving CFD portfolio of stocks that are technically positioned to show strength going forward.

We also offer trading on stock index CFDs. Indices are portfolios of stocks regularly rebalanced by the creators of the index.

ETFs periodically rebalance. How often, when, and why is laid out in the prospectus for the fund. Generally speaking, a fund rebalancing may have little effect on the investors in the fund.

In rare cases when a substantial change is required in an ETF to rebalance, this may result in an unforeseen taxable event where shareholders are paid out gains, and they must then pay capital gains on that amount (if the ETF is held in a taxable account).

This is rare but not totally avoidable since the events that cause this are unforeseen. For example, if there is as a major change in an underlying index that the ETF is tracking.

A stock index rebalancing is typically a non-event, just like with the ETFs mentioned above. The index sells stocks that are overweight and uses the funds to buy stocks that are underweight. The index then continues trading until another rebalance occurs.

What can cause a bigger stir is when a new stock is added to the index. Some investors buy stocks when it is announced they will be added to a major stock index, like the S&P 500. Since the index will need to accumulate shares of the company, the investors are trying to front-run that buying and hopefully profit from it. Stocks that are added to a major stock index tend to see a temporary price rise following the announcement. However, this is not always the case.

When a stock is dropped from an index, this is usually because it has been a weaker performer. Some traders may look at these stocks for a possible short trade, although this strategy is less common. Traders should be cautious with buying or selling a stock solely because it is being added or dropped from an index.