Rebalancing: Why, When and How

What you will learn

• Why a portfolio drifts away from its target mix and why that changes your risk.
• How calendar rules and tolerance bands decide when to rebalance.
• How to calculate the exact rebalancing trade and the cash-flow alternative.
• Which costs and taxes rebalancing can trigger in Germany.

Explanation

Choosing a target mix of equities, bonds and cash was covered in lesson 7.

Drift

Drift means that the weights in your portfolio move away from your targets because the parts grow at different speeds. After a long rise in share prices, a 60/40 portfolio (60% equities, 40% bonds) can become 70/30 without you buying anything. You then carry more risk than you decided to carry. After a crash, the opposite happens.

Rebalancing means bringing the weights back to the targets. Its main purpose is risk control: you keep the risk level you chose. It is not a reliable way to increase returns. In a market that rises for many years, rebalancing usually means selling some of the asset that keeps rising.

When: three common rules

• Calendar rule: check once a year on a fixed date (for example, your birthday) and rebalance if needed.
• Tolerance band rule: rebalance only when a weight leaves a band around its target. An absolute band of ±5 percentage points (pp) on a 60% target means acting below 55% or above 65%. A relative band of ±20% on a 10% position means acting below 8% or above 12%; relative bands suit small positions.
• Combined rule: look once or twice a year, and act only if a band is broken. This avoids many small trades and also avoids ignoring large moves.

Checking daily creates costly small trades; never checking lets risk drift without a decision.

How: two methods

• Selling and buying: sell the overweight part and buy the underweight part. Fast and exact, but it can cost order fees and spreads, and a sale with a gain can trigger tax.
• Cash-flow rebalancing: direct new savings, or distributions, only into the underweight part until the weights are back in the band. No sale, so no tax on gains. It works best while you are still saving and the drift is small.

The formula for the target value of any part is simple: target value = target weight × total portfolio value. The trade is the difference between the target value and the current value.

Worked example

Hypothetical example: a €50,000 portfolio with a 60/40 target: €30,000 in an equity ETF and €20,000 in a bond ETF. The rule is an absolute band of ±5 pp. Over two years the equity ETF rises 25% and the bond ETF falls 5%. We ignore fees and spreads; tax is shown separately as a simplified preview of lesson 12.

1. New values: equities €30,000 × 1.25 = €37,500; bonds €20,000 × 0.95 = €19,000. Total = €56,500.
2. Equity weight: €37,500 ÷ €56,500 = 66.4%. This is above 65%, so the band is broken.
3. Target equity value: 60% × €56,500 = €33,900. Sell €37,500 − €33,900 = €3,600 of the equity ETF and buy €3,600 of the bond ETF.
4. Cash-flow alternative: keep €37,500 in equities as 60% of a larger total. Total needed = €37,500 ÷ 0.60 = €62,500. Bonds needed = 40% × €62,500 = €25,000. New money into bonds = €25,000 − €19,000 = €6,000.
5. Simplified tax on the sale: assume the units sold contain the same share of gain as the whole position, €7,500 ÷ €37,500 = 20%. Gain = 20% × €3,600 = €720. For an equity ETF, 30% of the gain is tax-free (partial exemption, lesson 12), so €504 is taxable. If your annual tax-free allowance is already used, tax at 26.375% (25% plus solidarity surcharge, no church tax) = €132.93.

So the choice is: sell now and pay about €133 tax plus costs, or add €6,000 of new savings to bonds over the coming months.

Common mistake

Practice activity

Your target is 70/30. You start with €28,000 in equities and €12,000 in bonds. Equities then fall 20% and bonds rise 2%. Your rule is an absolute band of ±5 pp. Ignore costs and taxes.

1. Calculate the new values and the equity weight. Is the band broken?
2. What trade restores 70/30?
3. How much new money into equities would restore 70/30 without selling bonds?

Key takeaways

• Rebalancing restores the risk level you chose; it is risk control, not a return promise.
• A combined rule works well: review once or twice a year and act only when a band of about ±5 pp is broken.
• Target value = target weight × total value; the trade is the gap to the current value.
• Directing new savings to the underweight part avoids sales, costs and tax on gains.

Next step

In the next lesson you will calculate how compound growth works over decades and how much of the final result fees can take away.