Two Approaches to Rebalancing
Once an investor accepts that portfolios drift and that drift should be corrected, a practical question arises: how often, and by what trigger? There are two main approaches.
Calendar-based rebalancing sets a schedule: quarterly, semi-annually, or annually. On the scheduled date, the investor checks the portfolio weights and trades back toward the target allocation regardless of how much or how little drift has occurred. The advantage is simplicity and regularity. The disadvantage is that the calendar is arbitrary — a portfolio that has barely drifted may be traded unnecessarily, incurring costs, while a portfolio that drifts dramatically between dates may go uncorrected for too long.
Threshold-based rebalancing, sometimes called opportunistic rebalancing, triggers a rebalance only when an asset class deviates beyond a specified tolerance band — for example, if any asset class moves more than 5 percentage points from its target. A 60% equity target has a band of 55–65%; only if equities fall outside that range does rebalancing occur. Research by Glen Daryanani (2008) in the Journal of Financial Planning found that threshold-based rebalancing generally delivers better outcomes than calendar rebalancing because it responds to actual portfolio needs rather than arbitrary dates.
A hybrid approach combines both: check the portfolio on a regular schedule, but only trade if thresholds have been breached. This is the approach recommended by Vanguard Research in its 2015 paper "Best Practices for Portfolio Rebalancing."
Transaction Costs and Tax
Every rebalancing trade incurs costs. In execution, there are bid-ask spreads and any brokerage commissions. More significantly, in taxable accounts, selling an appreciated asset realises a capital gain, which may trigger a tax liability. Selling equities that have risen 50% to rebalance into bonds means paying tax on that gain immediately, which permanently reduces the compounding base.
This cost asymmetry matters. For investors in tax-advantaged accounts (ISAs, SIPPs, 401(k)s, IRAs), rebalancing has no tax consequences and should be done as cleanly as the arithmetic requires. For investors in taxable accounts, the calculus is more complex.
Rebalancing Without Selling
In taxable accounts, there is a cleaner alternative to selling appreciated assets: directing new contributions to underweight asset classes. If equities have grown and bonds have lagged, the investor simply channels their next salary contribution, dividend income, or bonus toward bonds until the allocation is restored. No selling, no taxable gain — the rebalance happens through the flow of new money.
This approach works best when new contributions are material relative to the portfolio size, which is most likely during the early accumulation phase. As the portfolio grows and contributions become smaller relative to total value, outright selling becomes increasingly necessary to maintain the target allocation.
Setting tolerance bands appropriately matters here: bands that are too tight force excessive trading; bands that are too wide allow meaningful risk drift to persist.