Rebalancing is a way to maintain the risk/reward ratio that you have chosen for your investments.
In addition, rebalancing also forces you to buy temporarily under-performing assets and sell over-performing assets (buy low, sell high). This is the exact opposite behavior of what is shown by many investors, which is to buy in when something is hot and over-performing, only to sell when the same investment becomes out of style (buy high, sell low).
However, in taxable accounts, rebalancing will create capital gains/losses and therefore tax consequences. In some brokerage accounts, rebalancing will incur commission costs or trading fees.
Some people rebalance on a certain time-based schedule – for example, once every 6-months, every year, or every 2 years. Others wait until certain asset classes shift a certain amount away from their desired targets before taking any action. A good source of research articles about which method is optimal can be found at the AltruistFA Reading Room. I’ve been reading through them the past few days, and I’ll try to provide a very general overview of the articles here.
So what is best? You may be surprised by the fact that not only is there no clear agreement on the answer to this question, but many of the articles actually contradict each other!
*** [now searching with google instead of bing, which was linked from moneycentral]
the correct question may not be “How often should I rebalance?”, but rather “How far should I allow my asset classes to stray from their target allocations before I rebalance?”. Rebalancing only when an asset class reaches 150% of the target allocation, for example, will perhaps result in a more tax efficient and more profitable portfolio.
there are two common methods when it comes to rebalance frequency. First, you can use a time-based interval. What this means is you rebalance on a regular schedule, regardless of what the market has done. Some people do this quarterly, while others semi-annually or annually. Basically, you set a date and a frequency and rebalance like clockwork.
While that will work, it is still fairly arbitrary and a lot can happen in the markets between your rebalance intervals. In my opinion, a better way is to set thresholds for your investment mix and rebalance based on when an investment crosses the threshold. For instance, if you set a threshold of 5% that would mean that any time one of your asset classes exceeds 5% of your target one way or the other, it’s time to rebalance back to your target. The key with this method is to set a threshold that isn’t so low that you’re rebalancing every month, but not so high that it takes five years before you exceed a threshold. Either way, the benefit of this method is that you’re rebalancing based on actual market conditions, not just an arbitrary timeline you set.