Why Rebalancing Annually Matters: A Historical Perspective

You set your target allocation: 60% stocks, 40% bonds. You invest your money and walk away. Five years later, you check your portfolio and discover it's now 75% stocks and 25% bonds.

What happened? And does it matter?

This is the story of portfolio drift - and why rebalancing annually might be the most important investing habit you're not doing.

What Is Rebalancing?

Rebalancing is the process of bringing your portfolio back to your target allocation. If your goal is 60/40 but market movements have shifted you to 75/25, rebalancing means selling some stocks and buying bonds to return to 60/40.

It sounds simple, but it requires discipline. You're selling your winners (stocks that grew) and buying your losers (bonds that didn't grow as much). This feels counterintuitive, but it's a proven risk management strategy.

The Math: What Happens Without Rebalancing?

Let's say you invest $10,000 in a 60/40 portfolio in 2010. You never rebalance. By 2020, here's what likely happened:

• Your stocks grew faster than bonds
• Your 60% stock allocation became 70-80% of your portfolio
• You're now taking more risk than you intended
• When the next crash comes, you'll lose more than you planned

This is called "portfolio drift." Your allocation drifts away from your target as different assets perform differently. Without rebalancing, you're essentially letting the market decide your risk level - and markets tend to push you toward higher risk over time.

Historical Evidence: The 2000-2020 Period

Let's look at what happened to a 60/40 portfolio during one of the most volatile periods in modern history.

Scenario 1: Never Rebalanced

An investor starts with 60/40 in 2000 and never rebalances. By 2007, their portfolio might be 70/30 or even 75/25 (stocks outperformed). When the 2008 crash hits, they lose more than they would have with a true 60/40 allocation.

After the crash, their portfolio might be 50/50 (stocks crashed harder). They still don't rebalance. As markets recover, stocks grow faster, and they drift back to 70/30. They're now taking more risk than their original plan.

Scenario 2: Rebalanced Annually

The same investor, but they rebalance every January 1st. When stocks outperform (2003-2007), they sell some stocks and buy bonds to maintain 60/40. When stocks crash (2008-2009), they sell bonds and buy stocks to maintain 60/40.

This systematic approach:

• Forces you to "sell high" (stocks at peaks)
• Forces you to "buy low" (stocks during crashes)
• Maintains your intended risk level
• Can improve returns over long periods

The "Buy Low, Sell High" Mechanism

Rebalancing is the only investment strategy that systematically forces you to buy low and sell high. Here's how:

When stocks outperform: Your allocation drifts to, say, 70/30. Rebalancing means selling stocks (high) and buying bonds (relatively low).

When stocks underperform: Your allocation drifts to, say, 50/50. Rebalancing means selling bonds (relatively high) and buying stocks (low).

This is the opposite of what most investors do instinctively. Most people buy more of what's performing well and sell what's performing poorly - exactly the wrong approach.

Real Numbers: The Impact Over 20 Years

Historical backtesting shows that rebalancing can add 0.5% to 1% to annual returns over long periods. That might not sound like much, but over 20 years:

• $10,000 at 7% annual return = $38,700
• $10,000 at 8% annual return = $46,600

That's a $7,900 difference - nearly 80% more money - just from rebalancing over 20 years.

More importantly, rebalancing reduces risk. A rebalanced portfolio will have lower volatility and smaller drawdowns during market crashes. You sleep better at night.

Common Rebalancing Strategies

1. Time-Based Rebalancing (Annual)

Rebalance on a fixed schedule: every January 1st, every quarter, or every month. This is simple and removes emotion from the decision.

Pros: Simple, systematic, no guesswork

Cons: Might rebalance when markets are stable (unnecessary trades)

2. Threshold-Based Rebalancing

Rebalance when your allocation drifts by a certain amount (e.g., 5% or 10% from target). If your target is 60/40, rebalance when you hit 65/35 or 55/45.

Pros: Only rebalances when needed, fewer trades

Cons: Requires monitoring, can be emotional

3. Hybrid Approach

Check annually, but only rebalance if drift exceeds your threshold (e.g., 5%). This combines the simplicity of time-based with the efficiency of threshold-based.

The Tax Consideration

Rebalancing in a taxable account creates tax events. Every time you sell, you realize capital gains (or losses). This is why many investors prefer to rebalance in tax-advantaged accounts (IRAs, 401(k)s, ISAs).

In taxable accounts, you can:

• Rebalance using new contributions (buy more of the underweighted asset)
• Use tax-loss harvesting (sell losers to offset gains)
• Rebalance less frequently (every 2-3 years instead of annually)

For most investors, rebalancing in retirement accounts is the simplest approach. You can rebalance freely without tax consequences.

Why Annual Rebalancing Works

Annual rebalancing strikes the right balance:

• Frequent enough: Prevents significant drift
• Infrequent enough: Avoids overtrading and taxes
• Simple: Easy to remember and execute
• Systematic: Removes emotion from the decision

Research shows that rebalancing more frequently (monthly or quarterly) doesn't significantly improve returns and increases trading costs. Rebalancing less frequently (every 2-3 years) allows too much drift.

Common Mistakes to Avoid

1. Rebalancing Too Frequently

Rebalancing daily or weekly is counterproductive. You're just adding trading costs and taxes without improving returns.

2. Never Rebalancing

Letting your portfolio drift indefinitely means you're taking more risk than you planned. When the next crash comes, you'll be overexposed.

3. Emotional Rebalancing

Rebalancing based on market predictions or fear is not rebalancing - it's market timing. Stick to your schedule.

4. Ignoring Tax Implications

In taxable accounts, be mindful of capital gains. Consider rebalancing with new contributions instead of selling.

How to Test Your Rebalancing Strategy

Curious how different rebalancing frequencies would have affected your portfolio? Historical backtesting can show you:

• How your allocation would have drifted without rebalancing
• The impact of annual vs. quarterly vs. never rebalancing
• How rebalancing affected returns and volatility
• Whether your specific allocation benefits from rebalancing

Not all portfolios benefit equally from rebalancing. If all your assets move together (high correlation), rebalancing has less impact. If your assets move independently (low correlation), rebalancing is more valuable.

Curious how rebalancing would have affected your specific portfolio? Test your exact allocation with and without annual rebalancing using our backtesting tool. See the real difference in returns, volatility, and risk - not just theory, but actual historical performance. It takes minutes to understand what rebalancing would have meant for your portfolio over the past 20-30 years.

Conclusion

Rebalancing annually is one of the few "free lunches" in investing. It forces you to buy low and sell high, maintains your intended risk level, and can improve returns over long periods. Yet most investors don't do it.

The historical evidence is clear: investors who rebalance systematically outperform those who don't, both in terms of returns and risk-adjusted performance. The key is to make it automatic - set a date, stick to it, and remove emotion from the process.

Your specific situation matters. Your allocation, your account types, your tax situation - all affect how and when you should rebalance. But the core principle remains: maintaining your target allocation through systematic rebalancing is one of the most important investing habits you can develop.

Ready to see the impact of rebalancing on your portfolio? Our portfolio backtesting tool shows you exactly how annual rebalancing would have affected your returns, risk, and portfolio drift over decades. Test your allocation, compare rebalancing strategies, and build confidence in your approach.