How to Rebalance Your Portfolio: Tax-Efficient Guide

Do you know how and when to rebalance your portfolio?  Most investors either don’t rebalance or practice this technique too hastily, which can hurt your portfolio’s performance.  Even well-seasoned financial advisors sometimes use poor practices, which could incur unnecessary taxes or fees. 

My goal here is simple- build wealth through improved returns and minimize unnecessary mistakes, taxes, and costs. 

No matter where you are on your investing journey, this complete tutorial will have some tactics you don’t know.  You must learn best practices and avoid common mistakes to maximize your wealth.

What is Portfolio Rebalancing?

Portfolio Rebalancing is a process used to minimize overall risk by adjusting asset allocations from portfolio drift levels back to ideal allocation targets.

This investment strategy seems reasonable and has become a foundation among financial advisors.  However, the process requires investors to sell some overperformers and buy more underperformers, inevitably realizing taxable capital gains.  Intelligent advisors often tiptoe around profits in taxable accounts by mentioning them as a consideration, yet they often still toe the industry line and convince investors it is vital.

Rebalancing Between Asset Classes vs. Rebalancing Within Asset Classes

Rebalancing between asset classes (such as from stocks to bonds) is perhaps the more critical rebalance because it achieves the goal of diversifying risk as different asset classes are less correlated to each other, which minimizes the overall level of risk.

Rebalancing within asset classes (such as from U.S. Large Cap to Small Cap) generally has less effect on minimizing market volatility.  This is because sectors within the same asset classes often move in a highly correlated fashion.  More region-specific stocks, such as international stocks, are usually less correlated to the US, so I prioritize rebalancing regions over sectors.  Investing in highly diversified, low-cost ETFs allows you to diversify single stock and sector risk within the ETFs.  Because ETFs rebalance themselves in a tax-efficient method, this is superior to holding and rebalancing a mix of stocks, which would require realizing taxable gains.

Portfolio rebalancing is a critical practice that should be performed, but best practices need to be followed to maximize profits and minimize taxes.

Why Should You Rebalance Your Portfolio?

Rebalancing minimizes portfolio volatility to a level determined in your investing plan and based on your risk tolerance.  Different asset classes have varying returns vs. risks associated with them.  Risky assets, such as stocks, have historically outperformed other asset classes in financial markets, but they are often subject to more volatility and could experience more considerable short-term losses. 

3 Benefits To Rebalancing Your Portfolio

Because of varying performance between different asset classes over time, rebalancing has three main benefits.

Re-establishing Targets and Minimizing Risk

The most crucial goal of rebalancing is to increase diversification throughout your entire portfolio.  Diversification across different asset classes minimizes overall volatility and maintains an appropriate risk when you stick to your target asset allocation.

Potential Gains From Buying Low and Selling High

Rebalancing your portfolio will generate increased returns when assets move, as you will be buying cheaper holdings and selling more expensive ones.  Leaving taxes aside, the process compels you buy underperforming assets and trim overperforming ones, which often results in increased returns when asset prices revert over time.

Removing Human Emotion and Bias

By committing to your asset allocation strategy, you remove personal bias and human emotion from investing- which will generally keep you out-performing the markets.  During a stock market downturn, rebalancing allows us to keep buying more stocks at lower prices (even if it feels scary).  Naturally, these will later be sold once the market rebounds and these assets become overweight.  Trimming high-performing assets and paying taxes is the common concern in rebalancing theory, but buying riskier assets (such as stocks) when they are cheap is an opportunity to rebalance and build wealth!

“I will tell you how to become rich.  Be fearful when others are greedy, Be greedy when others are fearful”

-Warren Buffett

Arguments Against Rebalancing Your Portfolio?

What happens if we decide not to rebalance our portfolio?  Ultimately a portfolio will likely drift toward an allocation that is not in line with our pre-established risk profile.  This will not necessarily hinder returns but will generally add more volatility to your profile than you target.

Trimming Higher Performing Assets

Over time a portfolio will generally slide its asset mix toward overweight in higher-performing stocks because they tend to overperform in the long run and will compound more quickly. 

John Bogle, the inventor of index funds and founder of Vanguard, famously concluded that rebalancing benefits offset the gains for long-term investors.  This argument supports a logical rationale for letting your winners compound and grow wealth in the long run.  Assuming you can handle the additional risk of letting your profits run, a longer-term outlook gives you more opportunity for greater compounding.

Choosing not to trim profits can make logical sense for investors who don’t have immediate needs for the cash flow and are willing to take more risk compared to their starting investment.  Often younger investors with a long time horizon can afford a higher risk level aiming for higher long-term returns.

Personally, as my wealth has grown over time, I don’t need the same target percentage in “safe assets.”  I prefer to be less aggressive when rebalancing my stocks into bonds during bull market conditions and only rebalance these when there are zero tax implications.

Realizing Taxes Reduces Compounding Returns

Realizing capital gains in a taxable account (such as a taxable brokerage account) is the most severe concern for most investors, reducing the portfolio’s ability to compound most efficiently.  Many investment advisors offer investment advice not to make decisions based on taxes during the rebalancing process.  That argument is absurd because compounding returns is crucial to building wealth.  Even small fees, taxes, and costs can have massive long-term implications. 

Realizing Additional Costs From Rebalancing Activities

Transaction costs may be high in certain types of accounts, creating an additional drag on a portfolio.  These days with so many low or zero-cost brokers, however, transaction costs are generally not a significant concern in most accounts. 

Some products (such as individual corporate or muni bonds) generally have a large bid-ask spread which could contribute to significant costs and should not be rebalanced.  Exchange-traded funds typically offer the lowest costs for investors and include all types of assets, such as bond funds, stock funds, and real estate funds.  Investors can ignore spread costs as insignificant (less than .03%) by investing and rebalancing with the most liquid, best ETFs.

As an investor’s tax rate increases (sometimes over 50% with state and local taxes), trimming profits and paying taxes has an even more pronounced drag on growth. 

Risk-averse investors allocating targets to less risky assets- such as bonds and cash- should be the most concerned about rebalancing to maintain a more conservative allocation.  Especially if the investor’s goal is to generate income for living, then rebalancing needs to be exercised with discipline.

Summary of Rebalancing Decision

With all the reasons for and against rebalancing, let’s summarize the best practices:

Without taxes and wanting to mitigate some risk, I would stick to rebalancing between asset classes.  Rebalancing without taxes takes advantage of buying cheaper assets and selling more expensive holdings, generating increased returns and minimizing volatility. 

I would err on rebalancing less when incurring any significant taxable gains.  Nevertheless, rebalancing during a large market correction (crash) is often a wise time to rebalance as you are reallocating to cheaper assets for usually fewer taxes than in rising markets.

When to Rebalance Your Portfolio?

There are 2 general techniques on when to rebalance a portfolio, based either on set movement thresholds or on a set time.

Threshold Based Portfolio Rebalancing

Using a threshold strategy to rebalance your portfolio is the best method and will present the most useful rebalance circumstances.  I recommend setting a threshold tolerance range at 5% of your targeted allocation percentage as a maximum range where you let your portfolio target drift before rebalancing.

The amount of potential tax is the key consideration when deciding to rebalance back to target amounts or just within the threshold limits.  Notwithstanding taxes, I aim to get as close to my initial target limits as possible.  If there will be significant capital gains, I will only rebalance the minimum amount necessary to return all assets within the threshold limits.

Time-Based Approach: When Should You Rebalance Your Portfolio?

Not only is there no perfect time to rebalance a portfolio, but in my professional experience choosing a set time is a poor strategy.  Firstly, selecting a set date (such as the end of the month or year) is arbitrary, and rebalancing should be based on how much the various assets are moving rather than a timeframe.

Combining The 2 Techniques: Threshold Setting With Timing

By committing to rebalancing when allocation thresholds are breached but reviewing our allocations at least periodically, we achieve the most optimal timing strategy for rebalancing.

I review my portfolio monthly.  I check the drifted allocation percentages against my targets and reallocate my cash to new investments in the most underweighted assets first. This method optimally combines dollar cost averaging with fixed amounts throughout the year and allocates these investments to the most underweight asset categories.  This technique is a crucial opportunity to rebalance without realizing any taxable gains.

How To Rebalance Your Portfolio Without Paying Taxes

Step By Step Guide to Portfolio Rebalancing

Step 1: Make an Investing Plan

Before conducting a portfolio rebalance, an investor must have formed an investment plan.  This plan outlines the financial goals, time horizon, and investment objectives, which can then be used to determine a balanced portfolio with appropriate target amounts for different types of investments. 

Portfolio Rebalancing is simply an investor’s technique to follow through on their investment plan.

Step 2: Review and Combine Assets Across All Accounts

When beginning to rebalance, the first step is to conduct a periodic review and total each asset category across all investment accounts.  This complete overview should include all investment assets, including retirement accounts.  Exclude your primary home and immediate and emergency cash, as these are not flexible investments.

Step 3: Calculate New Values To Buy and Sell

Next, calculate how total asset allocations have drifted from established targets and thresholds (explained above: Threshold Based Portfolio Rebalancing).  Setting a higher or lower threshold value will result in slightly more or less volatility and a minimal change to a portfolio’s long-term return.  Vanguard recommends using 5% as a reasonable threshold.

Step 4: Begin Rebalancing Using Cash First

Any new investments made with cash should be reinvested starting with the most underweight assets first.  This cash could come from sources such as stock dividends, interest payments, money from income, or RMDs- basically any cash already taxed.  This will always be the most tax-efficient technique and ideally strategically combines regular dollar cost averaging with portfolio rebalancing.

Step 5: Tax Loss Harvesting Techniques

Effective tax loss harvesting can allow for continued tax-efficient rebalancing by offsetting potential taxable capital gains with offsetting capital losses.  In a nutshell, tax loss harvesting is a technique to offset taxable gains with losses.  It can be combined with rebalancing practices to optimize tax efficiency.

Step 6: Use Your Retirement Accounts (Tax-Deferred Accounts)

Tax-advantaged retirement accounts, such as IRAs or 401ks, should not be considered separate from your portfolio but a piece.  In this manner, you could conduct your total portfolio level rebalances in these types of accounts, which defer tax.  As an added benefit, a tax-advantaged account may drift toward lower-risk assets such as bond funds (which we tend to buy over time to rebalance). A bond portfolio is well suited in a retirement account because interest is not eligible for long-term capital gains benefits.

Step 7: Continue Rebalance Only If Necessary

At this point, we have depleted the tax-efficient rebalancing methods, and I only continue to rebalance further toward my original allocation targets if I am still outside the 5% threshold in a given asset.

If you must use taxable profits to continue rebalancing, I look through my taxable brokerage accounts to find the best candidates with minor taxable gains.  Technically any positions that we could still rebalance for a loss should have been used during the tax loss harvesting rebalance step. 

Now we look for the lowest long-term capital gains or minimal short-term capital gains.  Our most recent purchases are often the best candidates for trimming as they won’t have as many substantial gains as older positions, but we need to scrutinize them to minimize capital gains taxes.

Always consider the taxes you will pay vs. the risk you will be mitigating before realizing a taxable gain when rebalancing.  The bigger your unrealized capital gain, the more consideration should be given before realizing the capital gain and owing taxes. 

Advanced Tax Efficient Strategies For Portfolio Rebalancing

Over time I have implemented some advanced tax-efficient strategies in my rebalancing to avoid taxes.

LIFO Accounting Method

I make my accounting method LIFO (last-in-first-out) in my investment account, which is often an available feature with several brokers in account settings.

This method offers significant benefits for long-term investment because it keeps your longest-held positions (generally the most significant unrealized capital gains) from being taxed during rebalances.  Using LIFO, my most recent taxable lots could often be rebalanced for less than my average cost basis or first bought shares.

Using Futures Contracts

Using futures contracts to rebalance is an advanced strategy unsuitable for most investors.  Portfolio rebalancing using futures contracts is a technique that allows an investor to effectively offset a position without realizing a taxable gain. 

Trading futures makes the most sense for investors who want to rebalance and have significant unrealized capital gains, which warrants using a more complex method of rebalancing.  I often rebalance with futures, and if you do it correctly, you can keep to your preferred portfolio allocation without realizing significant taxable gains.

Bottom Line Summary on Portfolio Rebalancing

Have any questions or comments? Feel free to contact me.

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