Pros & Cons of Rebalancing Your Portfolio (2024)

• Members discussed portfolio rebalancing, specifically the trade-off between two competing objectives: (1) maintaining a target allocation and risk profile, versus (2) minimizing tax drag by limiting portfolio churn. Over time, most portfolios will "drift" away from their target allocations, as strong returns from particular assets (usually individual stocks or equity funds) will cause them to become a larger share of the total portfolio
• The primarily reason to rebalance is to maintain a target volatility profile. Portfolio drift will typically increases portfolio volatility, both because greater concentration is inherently volatile and because high-return assets (e.g., equities) are more volatile then low-return assets (e.g., bonds).
• A secondary argument for rebalancing is to increase returns. Academic research suggests that investors can realize 0.5-1.5% higher annual returns through regular rebalancing between assets with similar expected return/volatility profiles. For example, an investor who rebalances to maintain a target allocation between US stocks and European stocks should on average "sell high and buy low" between those two markets and earn more than he would investing in either market alone. (Note that this anticipated benefit does not always materialize in reality; rebalancing from US to European stocks over the last 10 years would have reduced returns.)
• While rebalancing has strong benefits in theory, in practice portfolios that are heavily held in taxable brokerage accounts and whose positions have significant unrealized gains will suffer from significant tax drag and other transaction costs.
• Members employ several strategies to optimize the costs and benefits of rebalancing. First, wherever possible, investors should use new cash contributions to top-up underweight positions, rather than selling overweight holdings. Second, sales of appreciated positions should be happen first in tax-advantaged accounts (e.g., IRA / 401k). Other strategies include widening target allocation thresholds (e.g., 15-25% in EU stocks, rather than 18-22%), making charitable donations using appreciated securities rather than cash, and waiting to sell appreciated assets until they are eligible for long term capital gains tax treatment.

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