Asset Allocation and Rebalancing: Keeping Your Risk Where You Set It

Asset allocation is the split of your portfolio between broad types of investments, mainly stocks, bonds, and cash. It's the single biggest driver of how much a diversified portfolio swings up and down. A portfolio that is 90% stocks behaves very differently from one that is 40% stocks, regardless of which specific funds are inside.

Once you choose an allocation, markets immediately start changing it. This guide shows how that drift happens, what rebalancing accomplishes, and the common ways people do it.

The short version

• Asset allocation sets the balance between growth potential and volatility.
• Because stocks and bonds earn different returns, your allocation drifts over time, usually toward stocks after good years.
• Rebalancing means selling some of what has grown and buying what has lagged, to restore your target.
• In our example, a 60/40 portfolio drifted to about 69% stocks after five years. A 30% stock decline would then have cost 20.7% of the portfolio, versus 18.0% if it had been rebalanced.
• Rebalancing is mainly about controlling risk, not boosting returns.

How allocation shapes risk

Stocks have historically offered higher long-term growth with much larger short-term swings. High-quality bonds have generally offered lower returns with smaller swings. Mixing them creates a portfolio whose risk sits somewhere in between.

How people choose an allocation usually depends on:

• Time horizon: money needed within a few years generally can't afford deep stock losses.
• Risk capacity: your financial ability to absorb losses without changing your life.
• Risk tolerance: your emotional ability to stay invested during declines.
• Other income: pensions or Social Security can make a portfolio's swings less critical.

How drift happens

A hypothetical $100,000 portfolio starts at 60% stocks / 40% bonds. Over five years it earns these made-up returns:

If nothing is rebalanced, the stock share at each year-end becomes:

After five years, a portfolio intended to be 60% stocks is about 69% stocks, without the investor deciding to take more risk.

What drift does when markets fall

At the end of year five, both versions of the portfolio are worth almost the same: about $148,700 unrebalanced and $148,500 rebalanced annually. The difference is in what's at risk.

Now suppose stocks fall 30% the following year (bonds flat, for simplicity):

The drifted portfolio loses about $4,000 more, and more importantly, it behaves like a riskier portfolio than the investor chose. For someone near retirement, that difference matters; see sequence-of-returns risk.

What rebalancing does and doesn't do

It does:

• keep risk at the level you chose;
• impose a discipline of trimming what has grown and adding to what has fallen;
• prevent a portfolio from slowly becoming something you'd never pick on purpose.

It doesn't necessarily:

• increase returns. In long rising markets, letting stocks run would often have produced higher returns, along with higher risk. Rebalancing can help returns in choppy, mean-reverting markets and hurt in trending ones.

The main reason to rebalance is risk control. Any return effect is secondary and unpredictable.

Ways to rebalance

Calendar rebalancing. Rebalance on a set schedule, such as once a year. Simple and easy to remember.

Threshold (band) rebalancing. Rebalance only when an asset class drifts beyond a set band, such as 5 percentage points from target. In our example, a 60% target with a 5-point band would trigger rebalancing at 65%, which happened in year two.

Combination. Check on a schedule, but act only if outside the band.

Using cash flows. Direct new contributions to whatever is underweight, or take withdrawals from whatever is overweight. This rebalances gradually without selling.

Automatic. Target-date funds, balanced funds, and many managed accounts rebalance internally.

Taxes and costs

• In tax-advantaged accounts, rebalancing generally doesn't create taxable gains.
• In taxable accounts, selling winners can trigger capital gains taxes. Using new contributions, dividends, or rebalancing inside retirement accounts can reduce that.
• Trading costs are low or zero at many brokerages, but fund-level costs and bid-ask spreads still exist.

Changing your allocation over time

Rebalancing restores the same target. Separately, many people shift their target gradually as goals approach, usually toward more bonds and cash. Target-date funds follow a predefined path called a glide path. Whatever approach you use, write the target down so drift and emotion don't quietly change it for you.

The takeaway

Your asset allocation determines most of your portfolio's risk, and markets constantly push it off target. Rebalancing brings it back. It won't reliably increase returns, but it keeps your portfolio's risk where you decided it should be, which is the point of choosing an allocation in the first place.