How do you rebalance your portfolio?

Rebalancing means moving your investments back to the mix of stocks, bonds and cash you chose, after market moves have pushed it off target. Most people do it once a year, or when a holding drifts more than about 5 percentage points, and they do it inside retirement accounts or with new money to avoid taxes.

Your mix drifts on its own

Different investments grow at different speeds. When stocks rise faster than bonds, stocks become a bigger share of your money, and your portfolio becomes riskier than the mix you chose.

There are two ways to time it

You can rebalance on a calendar, such as every 6 or 12 months, or when a holding drifts past a band you set in advance, such as 5 percentage points. Both work. Picking one and sticking to it matters most.

There are three ways to do it

Sell some of what is over target and buy what is under, send new contributions to what is under, or redirect dividends. The last two avoid selling.

Taxes depend on the account

Trades inside a 401(k), IRA or HSA are not taxed. Selling at a gain in a regular brokerage account creates a capital gain you owe tax on that year.

Why portfolios drift

Say you choose 70% stocks and 30% bonds. If stocks rise 20% in a year and bonds stay flat, stocks are now a larger slice. In the example below, $14,000 of stocks grows to $18,000 while bonds stay at $6,000, and the mix becomes 75% stocks.

The opposite happens after a stock market drop. Stocks shrink to a smaller share, and you end up holding less in stocks than your plan calls for, right when prices are low.

How often to rebalance

The SEC's beginner's guide describes two approaches. One uses the calendar: check your mix every 6 or 12 months and fix it. The other uses your investments: act only when a holding moves more than a set amount from its target. It adds that rebalancing tends to work best when done relatively infrequently.

A simple rule combines both. Check once a year, and rebalance only if something is more than 5 percentage points off. Small drifts are not worth the trades, and checking every week makes it tempting to react to news.

How to rebalance, step by step

Step 1: add up everything you hold across all accounts. Step 2: work out what percentage is in stocks, bonds and cash. Step 3: multiply your total by each target percentage to get the dollar amount each should be. Step 4: the difference between the target and what you hold is how much to move.

To move it, you can sell some of the overweight holding and buy the underweight one. Or, if you contribute every month, send all new money to the underweight holding until the mix is back. If you need to put a lot in to fix it, selling inside a retirement account is usually quicker.

Keeping taxes and costs low

Do your selling inside tax-advantaged accounts like a 401(k) or IRA, where trades have no tax consequences. Many 401(k) plans also have a setting that rebalances your account automatically once a year or once a quarter.

In a taxable brokerage account, selling a fund that has gained value creates a capital gain. Using new contributions and dividends to buy the underweight holding avoids that. If you must sell in a taxable account, shares held more than 1 year are taxed at the lower long-term rates.

When you can skip it

A target-date fund or a balanced fund holds stocks and bonds in one fund and rebalances on its own. If that one fund is your whole portfolio, there is nothing for you to rebalance.

Some people also change their target as they age, moving gradually toward bonds as a goal gets closer. That is a planned change to the target itself, decided ahead of time, which is different from reacting to a good or bad year.