The Importance of Rebalancing in Portfolio Management

Introduction: Why Rebalancing is Critical for Long-Term Investing Success

Most investors believe that once they pick good stocks, their main job is done. This is not true.

First, you need to decide how much of your portfolio to allocate to each stock. You may choose to keep it simple and just equal weight everything. Or you may want to use more sophisticated strategies to manage risk. Regardless of how you choose to allocate, there is another step you need to take (again and again) to keep your portfolio aligned with your goals.

Rebalance it frequently.

Over time, investments drift from their original allocations as some holdings outperform while others lag. Without rebalancing, a portfolio can become riskier than intended, leading to suboptimal returns. Whether you follow an equal-weighted, Kelly Criterion, or risk-parity approach, rebalancing is a non-negotiable tool to keep your investments aligned with your strategy.

I have posed the question of rebalancing on Bluesky and Substack Notes a few times, and while many swear by it, there are also many who insist that letting the winners run is a better strategy. I used to be solidly on the “letting the winners run” camp. In fact, many legendary investors, including Warren Buffett, have built their wealth by letting winners run. But that doesn’t mean you should ignore rebalancing. The process is fundamental to risk control, capital efficiency, and long-term compounding—especially for value investors who seek to buy assets at a discount and sell when they reach intrinsic value.

What is Rebalancing and Why Does It Matter?

I am now firmly on the side of Rebalancing. Rebalancing is the process of adjusting your portfolio back to a target allocation. This means selling assets that have grown beyond their intended share of the portfolio and reinvesting in those that have shrunk below their target weight.

For example, if you started with a 60/40 stock-bond allocation and stocks performed exceptionally well, you might end up with 70% in stocks and 30% in bonds. Rebalancing would involve selling stocks and buying bonds to restore the original 60/40 mix.

In an all stock portfolio, you would still rebalance to bring the portfolio back to its intended allocation. Here the buy and sell transaction would adjust the allocations of the stocks that make up the portfolio. Sell the stock that has gone up enough to bring it down to the target allocation, and buy the stock that has gone down enough to bring it up to the target allocation for that stock.

While this may seem counterintuitive—reducing winners and adding to underperformers—it is, in fact, a structured way of systematically buying low and selling high.

Remember, buying low and selling high is the guaranteed (and the only) way to make money investing in stocks.

Value Investing and the Rebalancing Debate

Value investors typically focus on stocks trading below their intrinsic value. Some argue that rebalancing forces you to sell winning stocks too soon, but this argument misses a key point: not all stocks that go up remain great investments.

• If a stock has reached or exceeded its intrinsic value, selling it to reallocate capital to undervalued opportunities improves long-term returns. Many investors carry away with a rising stock – they hold on to it even when they know that the valuation is becoming rich. Often the result is a sudden loss of the profits that could have been booked if the investor had stayed true to their investment process.
• If a stock’s fundamentals improve alongside price appreciation, a reassessment of its intrinsic value is warranted before reducing allocation. This may very well increase the allocation of the stock in the portfolio, and therefore, rebalancing will actually buy more of this stock.

This disciplined approach ensures that investors don’t hold overvalued stocks indefinitely, which is a risk many fail to consider. It also accounts for the changes in the intrinsic value before you rebalance, so as to be adaptable to the valuation changes.

You don’t want to sell too early and you don’t want to hold on until it is too late.

The Rebalancing Bonus: A Hidden Advantage

Beyond maintaining a desired risk-return profile, rebalancing has another benefit—it can actually enhance portfolio performance through a concept known as the “rebalancing bonus.”

This occurs because rebalancing systematically moves capital into assets that are temporarily underpriced and out of assets that may be overextended. Over multiple cycles, this incremental discipline compounds into superior long-term performance.

Think of this as small incremental dividends that you pay yourself and then reinvest it into the stock, in addition to whatever the stock is paying you.

Studies, including those by William Bernstein, show that periodic rebalancing can generate excess returns compared to a buy-and-hold strategy, especially in volatile markets. The key reason? It forces you to take profits from assets that have become expensive and reinvest in those with higher expected future returns.

Rebalancing Works Across All Allocation Strategies

Rebalancing isn’t just for traditional 60/40 portfolios. It applies across different portfolio construction methods, including:

1. Equal Weighting: Ensures that no single stock dominates the portfolio over time, avoiding excessive concentration risk. I generally keep my Dividend Growth Portfolio as equal weight portfolio as my strategy there is long term consistent compounding.
2. Kelly Criterion Allocation: Maintains a mathematically optimal bet sizing strategy, adjusting as probabilities and expected returns shift. My Premium small cap value portfolio is allocated using Kelly Criterion where the allocation levels change based on the expected returns, volatility and correlations between stocks in the portfolio. As the prices go up or down, my allocations change and I rebalance. This gives me a mathematically optimal growth portfolio.
3. Risk Parity: Keeps asset class risk contributions balanced to avoid overexposure to highly volatile securities. Here the allocation percentages are chosen so that each stock contributes an equal amount or risk in the portfolio. You can imagine that the portfolio characteristics can completely change as stock prices change.

Regardless of your preferred allocation framework, failing to rebalance can distort risk exposure and reduce compounding efficiency.

How Often Should You Rebalance?

Theoretically, if rebalancing gets you a rebalancing bonus, you would want as much of it as possible. Therefore a continuous rebalancing portfolio will maximize the compounding. In practice, this is highly impractical as there are considerations of time, effort, transaction costs that needs to be weighed against the potential benefit.

The ideal rebalancing frequency depends on:

• Market volatility: More volatility requires more frequent checks.
• Tax implications: Excessive trading may trigger capital gains taxes, most of which will be short term. Additionally, wash sale rules will complicate your situation and may actually make the process suboptimal if you are required to defer your tax losses.
• Trading costs: Too frequent rebalancing can eat into returns if transaction fees are high. Even with the zero commission brokers, you do incur a transaction cost in form of the bid-ask spread on your stock. Stocks with low liquidity will be very expensive to trade.

A common approach is to rebalance quarterly or annually, but a more sophisticated method is threshold-based rebalancing, where rebalancing is triggered only when an asset drifts beyond a predefined percentage, say 5%. In cases where you pay a transaction cost that is based on the trade size (for example, bitcoin), threshold-based rebalancing is a good approach as you can set your threshold to be higher than your round trip transaction fee (otherwise all your rebalancing bonus will go to pay the broker).

Conclusion: Stay Disciplined, Stay Profitable

Rebalancing is not about market timing—it’s about discipline. The goal is to maintain a risk-optimal portfolio while systematically capturing the benefits of price fluctuations. Whether you’re a value investor seeking deep discounts or an optimizer using Kelly fractions, a structured rebalancing strategy is key to maximizing long-term returns.

Ignoring rebalancing is not a strategy; it’s a risk. Stay ahead of it, and your portfolio will reward you over time.

Sources

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