In the investing world, people are constantly searching for the edge. The secret strategy. The alpha-generating insight that separates the winners from everyone else. Billions of dollars are spent annually on research, analysis, trading systems, and advisory fees — all in pursuit of better returns.
Meanwhile, there's a simple, systematic behavior that is available to every investor for free, takes about 20-30 minutes per year, forces you to buy low and sell high automatically, and has been documented to improve risk-adjusted returns in most scenarios.
It's called rebalancing, and almost nobody talks about it with the enthusiasm it deserves.
What Rebalancing Actually Is
If you own a portfolio with target allocations — say, 70% stocks and 30% bonds — those percentages will drift over time as different assets perform differently. After a strong stock market year, your portfolio might be 85% stocks and 15% bonds. After a crash, it might be 55% stocks and 45% bonds.
Rebalancing is the act of selling the overweight assets and buying the underweight assets to return to your target allocation.
That's it. No prediction required. No market timing. No fundamental analysis. You're just mechanically restoring the ratios you decided on in advance.
The magic is in what this simple act requires you to do: buy low and sell high, automatically, without having to feel good about it.
When stocks have crashed, bonds are your overweight asset. Rebalancing requires you to sell bonds and buy stocks (after they've fallen). Your emotions are screaming "don't buy more stocks, the market is collapsing!" Your rebalancing rules force you to do the right thing anyway. That enforced discipline is enormously valuable.
When stocks have surged, rebalancing requires you to trim equities and add to bonds. Again, your emotions are saying "let the winners run!" The rules override the emotion.
The Math Behind Rebalancing Returns
Morningstar's research on rebalancing establishes a key mathematical principle: if two assets have the same long-term total return, rebalancing always produces higher returns than a buy-and-hold no-rebalancing approach. This is a mathematical certainty, not a hypothesis.
The intuition: if two assets end at the same place but take different paths to get there, systematically buying the laggard and trimming the leader captures the volatility of the journey as profit. Higher volatility between assets means more rebalancing benefit.
Vanguard's research found that a 60/40 equity/bond portfolio left untouched from 1989 would have drifted to approximately 80% equities by 2021. That's not the portfolio you intended to own. The risk profile changed dramatically from what you originally chose — and you probably didn't even notice.
Morgan Stanley's analysis found that combining annual rebalancing with 10-20% tolerance bands modestly improved risk-adjusted returns across investment strategies. The combination of time-based and threshold-based rebalancing appears to be more effective than either approach alone.
How Often Should You Rebalance?
The answer for most individual investors is once per year.
More frequent rebalancing (monthly or quarterly) generates higher transaction costs and, in taxable accounts, more capital gains events. The return benefit of rebalancing more frequently than annually is minimal for most portfolios.
Annual rebalancing aligns well with natural calendar checkpoints — the new year, your birthday, tax season — making it easy to remember and execute consistently. Set a reminder. Open your accounts. Look at your allocation versus target. Rebalance if materially off. Done.
The threshold-based approach is an alternative: only rebalance when an asset drifts more than 5% or 10% from its target. This might mean rebalancing every 8 months in a volatile market and every 18 months in a calm one.
For most investors, a hybrid is optimal: check once per year and rebalance if you've drifted more than 5% from targets. This avoids unnecessary trading while ensuring you don't let a bull or bear market completely change your allocation.
The drift problem in real numbers
Imagine you start 2020 at 60% VTI / 20% AVUV / 20% AVDV. After two years where VTI surges and AVUV/AVDV lag, your actual allocation might be 75% VTI / 14% AVUV / 11% AVDV. You've passively become a much more VTI-concentrated investor — not because you made a decision, but because you didn't make one. Your factor tilts, the whole reason you added AVUV and AVDV, have been diluted by half. Rebalancing back to targets restores your intended strategy and, in the process, forces you to buy more of the relatively underperforming assets — exactly what the factor investor should be doing.
The Tax-Smart Way to Rebalance
For taxable accounts, selling winners to rebalance triggers capital gains taxes. This is a real cost that shouldn't be dismissed. Here's how to minimize it:
- Use new contributions first. Instead of selling anything, direct new money into whatever asset is underweight. If your stocks are at target and your bonds are 5% underweight, your next three months of contributions go to bonds. This rebalances without selling.
- Rebalance inside tax-advantaged accounts. Your 401k and IRA are the right place to do any selling for rebalancing purposes. No capital gains taxes inside these accounts.
- Use dividends. Many brokerages allow you to automatically reinvest dividends in any fund. Directing dividend reinvestment to underweight assets is a painless rebalancing mechanism.
- Tax-loss harvesting. If an asset is down, you can sell it (realizing a loss for tax purposes), immediately buy a similar-but-not-identical fund, and use the tax loss to offset gains elsewhere.
Rebalancing in a Multi-Factor Portfolio
For VTI & Chill investors in the Better or Best tiers, rebalancing serves an additional function: it maintains your factor exposure.
Imagine your portfolio is 60% VTI, 20% AVUV, and 20% AVDV. After a year where US stocks crush everything, VTI might be 75% of your portfolio while AVUV and AVDV have shrunk. Your factor tilts — the whole reason you added those funds — have diminished. Rebalancing restores your intended factor exposure and, incidentally, forces you to buy the underperforming international and small cap value ETFs at lower relative prices.
This is why Merriman's Ultimate Buy and Hold strategy explicitly recommends annual rebalancing. The multi-asset-class structure only delivers its diversification and factor benefits if you actually maintain the allocations. Drift, left uncorrected, turns a carefully constructed factor portfolio into something much closer to a plain S&P 500 fund.
Rebalancing as pre-commitment to rational behavior
Think of rebalancing as a contract you make with yourself when you're calm, clear-headed, and thinking long-term — and then enforcing it when your emotions are at their most irrational. Market crashes feel catastrophic. Your rebalancing rules require you to buy. Market bubbles feel euphoric. Your rules require you to trim. You're essentially outsourcing your investment decisions to your past rational self, preventing future emotional self from making the most expensive mistakes in investing. This is the real "free lunch" — not just better returns, but protection from your own worst instincts, automatically, every year.
The Bottom Line
Rebalancing is the closest thing to a free lunch that exists in investing. It mechanically forces buy-low-sell-high behavior. It maintains your intended risk profile as markets move. It reinforces factor exposure in diversified portfolios. It provides a psychological anchor against the most expensive emotional mistakes.
Do it annually. Use new contributions to rebalance before selling anything. Do the selling inside tax-advantaged accounts. Keep it simple and mechanical. For a multi-factor portfolio, rebalancing is especially critical — it's the mechanism that keeps your factor tilts working as intended instead of drifting back toward plain VTI.
For a strategy that takes 30 minutes per year, rebalancing punches well above its weight class. Not because it's complicated — but because it keeps you doing the things that matter (maintaining allocation, buying dips) when your emotions are pushing you in exactly the wrong direction.
Disclaimer: VTI & Chill provides financial EDUCATION, not personalized financial ADVICE. We are not licensed financial advisors. All content is for informational and educational purposes only. Past performance does not guarantee future results. Always do your own research and consider consulting a qualified financial professional before making investment decisions. All investing involves risk, including the possible loss of principal.