So you've established an asset allocation strategy that is right for you, but at the end of the year, you find that the weighting of each fund in your portfolio has changed. What happened? Over the course of the year, the market value of each fund within your portfolio earned a different return, resulting in a weighting change. Mutual fund rebalancing is like a tune-up for your car: it allows you to keep your risk level in check and minimize catastrophe.

What Is Rebalancing?
Rebalancing is the process of buying and selling portions of your portfolio in order to set the weight of each fund in your overall investment back to its original state. In addition, if your investment strategy or tolerance for risk has changed, you can use rebalancing to readjust the weightings of each fund in the portfolio to fulfill a newly devised asset allocation.

Blown Out of Proportion
The asset mix originally created by an investor inevitably changes as a result of differing returns among various funds. As a result, the percentage that you've allocated to different funds (and sectors) will change. This change may increase or decrease the risk of your portfolio, so let's compare a rebalanced portfolio to one in which changes were ignored, and then we'll look at the potential consequences of neglected allocations in a portfolio.

Let us run through a simple example. Bob has $100,000 to invest. He decides to invest 50% in a bond fund, 10% in a Treasury fund and 40% in an equity fund.


At the end of the year, Bob finds that the equity portion of his portfolio dramatically outperformed the bond and Treasury portions. This has caused a change in his allocation of assets, increasing the percentage that he has in the equity fund while decreasing the amount invested in the Treasury and bond funds.


More specifically, the above chart shows that Bob's $40,000 investment in the equity fund has grown to $55,000, an increase of 37%! Conversely, the bond fund suffered, realizing a loss of 5%, but the Treasury fund realized a modest increase of 4%. The overall return on Bob's portfolio was 12.9%, but now there is more weight on equities than on bonds. Bob might be willing to leave the asset mix as is for the time being, but leaving it too long could result in an overweighting in the equity fund, which is riskier than the bond and Treasury funds. (For related reading, check out 4 Steps To Building A Profitable Portfolio.)

Consequences of Ignoring Disproportion
A popular misconception among many investors is that if an investment has performed well over the last year, it should perform well over the next year. Unfortunately, past performance is not always an indication of future performance - this is a fact many mutual funds disclose. Many investors, however, remain heavily invested in last year's "winning" fund and may drop their portfolio weighting in last year's "losing" fixed-income fund. Remember, equities are more volatile than fixed-income securities, so last year's large gains may translate into horrible losses over the next year.

Let's continue with Bob's portfolio and compare the portfolio values of his rebalanced fund with the funds left unchanged.


At the end of the second year, the equity fund performs poorly, losing 7%. At the same time the bond fund performs well, appreciating 15%, and Treasuries remain relatively stable with a 2% increase. If Bob rebalanced his portfolio the previous year, his total portfolio value would be $118,500, an increase of 5%. If Bob left his portfolio alone with the skewed weightings, his total portfolio value would be $116,858, an increase of only 3.5%. In this case, rebalancing is the optimal strategy.


However, if the stock market rallies again throughout the second year, the equity fund will appreciate more and the ignored portfolio may realize a greater appreciation in value than the bond fund. Just as with many hedging strategies, upside potential may be limited, but by rebalancing you are nevertheless adhering to your risk-return tolerance level. Risk-loving investors are able to tolerate the gains and losses associated with a heavy weighting in an equity fund, and risk-averse investors, who choose the safety offered in Treasury and fixed-income funds, are willing to accept limited upside potential in exchange for greater investment security.

How to Rebalance Your Portfolio

The optimal frequency of portfolio rebalancing depends on your transaction costs, tax considerations and personal preferences. Usually, rebalancing about once a year is sufficient; if some assets in your portfolio haven't experienced a large appreciation within the year, longer time periods may also be appropriate. Additionally, changes in your lifestyle may warrant a change to your asset allocation strategy. Whatever your preference, the basic steps for rebalancing your portfolio are as follows:

  1. Record - If you have recently decided on an asset allocation strategy that's perfect for you and purchased the appropriate mutual funds, keep a record of the total cost of each fund at that time, as well as the total cost of your portfolio. These numbers will provide you with historical data for your portfolio, so at a future date you can compare them to current values.
  2. Compare - On a chosen future date, review the current value of your portfolio and of each individual fund. Calculate the weightings of each fund in your portfolio by dividing the current value of each fund by the total current portfolio value. Compare these figures to the original weightings. Are there any significant changes? If not, and if you have no need to liquidate your portfolio in the short term, it may be better to remain passive.
  3. Adjust - If you find that changes in the fund weightings have distorted your portfolio's exposure to risk, take the current total value of your portfolio and multiply it by each of the (percentage) weightings originally assigned to each fund. The figures you calculate will be the amounts you should have invested in each fund in order to maintain your original asset allocation. Sell portions of mutual funds whose weights are too high and purchase additional units of mutual funds whose weights have declined.

Rebalancing your portfolio will help you maintain your original asset allocation strategy or implement any changes you make to your investing style. Essentially, rebalancing will help you stick to your investing plan regardless of what the market does.

Related Articles
  1. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  2. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  3. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  4. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  5. Retirement

    Two Heads Are Better Than One With Your Finances

    We discuss the advantages of seeking professional help when it comes to managing our retirement account.
  6. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  7. Professionals

    A Day in the Life of a Hedge Fund Manager

    Learn what a typical early morning to late evening workday for a hedge fund manager consists of and looks like from beginning to end.
  8. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  9. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  10. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  1. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  2. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
  3. Does OptionsHouse have mutual funds?

    OptionsHouse has access to some mutual funds, but it depends on the fund in which the investor is looking to buy shares. ... Read Full Answer >>
  4. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  5. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  6. When are mutual fund orders executed?

    Whether buying or selling shares of a fund, mutual fund trades are executed once per day after the market close at 4 p.m. ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center