Rebalancing: getting your portfolio back on course

Basics8 min read · updated 2 September 2026 · 7 sources

With rebalancing, you bring a portfolio whose weights have drifted because of price movements back to its target allocation. This keeps the risk where you want it and forces you to sell some of the assets that have risen and buy more of those that have fallen. Whether it also adds return depends on how the markets move.

An example with 60/40

After rebalancing, the portfolio once again has exactly the risk you originally chose. Without rebalancing, the equity share would keep rising during long bull markets, and with it the volatility and the potential drawdown.

Why rebalance at all?

An easy-to-read introduction to asset allocation, correlation and rebalancing using long historical series is Bernstein (2000).

The target allocation is the most important decision in investing: it determines how much volatility you have to endure and what return you can expect. Rebalancing is the tool that enforces this decision over the years. There are three reasons to do it:

• Keeping risk constant: without rebalancing, the market determines the allocation. After good years, risk rises precisely when equities have become more expensive.
• Discipline: the rule takes the decision out of your hands to buy more after a crash or take profits after a rally, which is exactly what feels hard emotionally.
• Diversification return: for assets with similar returns and low correlation, regular rebalancing can slightly increase the long-term growth rate (more on this below).

How often? Calendar or tolerance bands

With an absolute band of 5 percentage points, a 60% equity share is only rebalanced below 55% or above 65%. A relative band of 20% adapts to the size of the position: for a position with a 10% target, the corridor is then 8 to 12%, and for the 60% position 48 to 72%. Small satellite positions such as gold or emerging markets tend to need relative limits, otherwise they are never rebalanced.

Studies and backtests usually show only small differences in return between the intervals. Masters (2003) proposes deriving the width of the bands for each asset class from its trading costs and its contribution to risk: expensive or low-risk positions get wider bands. Donohue and Yip (2003) show that, with transaction costs, it is optimal to leave a no-trade corridor around the target and, when it is breached, to rebalance only back to the edge of the corridor, not all the way to the target. This saves turnover when markets only swing out briefly.

Costs and taxes

• Order fees and the spread are incurred on every sale and purchase.
• Taxes: in Germany, every sale at a gain triggers the flat-rate withholding tax (Abgeltungsteuer) once the saver's allowance (Sparer-Pauschbetrag) has been used up. The money is then missing from the portfolio.
• Rebalancing with contributions: instead of selling, you direct the monthly contribution into the underweight positions. This costs no tax and is often enough for small deviations.
• Withdrawals, conversely, can be taken from the overweight positions.

Does rebalancing add return? The diversification return

The long-term growth rate of a portfolio lies below its average annual return, and the more it fluctuates, the larger the gap (see volatility drag). A regularly rebalanced portfolio of weakly correlated assets fluctuates less than its components. Booth and Fama (1992) showed that its geometric return is therefore higher than the weighted average of the individual geometric returns. This extra is called the diversification return; Fernholz and Shay (1982) derived it in their stochastic portfolio theory.

Willenbrock (2011) stresses that this return only arises through rebalancing. A portfolio that you simply leave alone also gains, but for a different reason: the most successful asset grows into an ever larger share. If the expected returns are far apart (equities versus the money market), rebalancing costs return instead, because it keeps taking money out of the higher-returning asset. In exchange, it buys more stable risk.

For advanced readers: rebalancing as a bet on volatility

Perold and Sharpe (1988) compared rebalancing rules as dynamic strategies. Buy and hold moves linearly with the stock market. A constant mix, i.e. classic rebalancing, buys after losses and sells after gains. It wins in markets that swing back and forth and loses in markets with a clear trend. Portfolio insurance strategies such as CPPI do the opposite: they sell in falling markets and buy in rising ones. That is good in trends and bad in a zigzag market.

Which rule performs better therefore depends on whether markets tend towards reversal or towards trends. Over the decades there has been both: in the short term, stock markets show momentum; over several years, reversal is more common. That is why the rule of thumb is not to rebalance too often: monthly rebalancing works against short-term trends, annual rebalancing leaves them room.

If you want to be more precise, you can treat rebalancing as an optimisation problem: deviating from the target costs expected utility (more or less risk than intended), and trading costs fees, spread and taxes. The optimal rule is then a corridor whose width grows with the costs and shrinks with the volatility of the asset.

Common mistakes

• Rebalancing too often: monthly rebalancing with sales increases costs and taxes without managing risk noticeably better than a band.
• Not rebalancing at all: after long bull markets, the portfolio carries more risk than the plan says. Usually you only notice in the next crash.
• Wasting your tax-free allowance: if you have to sell anyway, time the sale so that the saver's allowance is used.
• Looking only at individual positions: what matters is the allocation across asset classes. Rebalancing two highly correlated equity ETFs against each other achieves little.
• Suspending the rule in a crash: that is exactly when rebalancing requires buying equities. If you cannot stick with that, you should choose a lower equity allocation.

How Portfolio Lab calculates it

In the Backtest, you choose no rebalancing, monthly, quarterly, semi-annually, annually or a tolerance band. With a calendar rule, the portfolio is reset to the target weights on the last trading day of the period. The band is absolute (default ±5 percentage points, selectable from 1 to 50): if a weight deviates by more than that, the whole portfolio is reset to the target; with daily prices, you can specify that the check only takes place at month-end. The contribution can be split according to target weights or go into underweight positions first (rebalancing without selling); withdrawals then come from overweight positions first. Order fees, spread and, optionally, German taxes reduce the result. The Rebalancing page turns your holdings into an order list in units: full, purchases only or sales only, with its own band. More in the backtest methodology.

This article explains a method; it is not investment or tax advice. Worked examples are simplified and rounded. All terms in the glossary.