Does Portfolio Rebalancing Actually Improve Returns?

Portfolio rebalancing is often discussed alongside asset allocation, risk management, and long-term investing. Over time, changes in the stock market, bond prices, and other asset classes can shift the makeup of an investment portfolio away from its original target allocation. Rebalancing refers to adjusting those holdings so the portfolio moves closer to a desired asset allocation again.

Some investors view portfolio rebalancing as a way to manage risk or maintain consistency through different market cycles. Others focus on whether a rebalanced portfolio could influence long-term returns. The answer may depend on several factors, including market conditions, transaction costs, tax considerations, and how frequently portfolio rebalancing takes place. For most investors, the evidence suggests rebalancing is more reliably associated with managing risk and maintaining a consistent asset mix than with consistently improving raw returns, though the two are not mutually exclusive. 

This article explores how portfolio rebalancing works, why investors use it, and whether it could improve returns over time.

What Is Portfolio Rebalancing?

Portfolio rebalancing refers to the process of realigning an investment portfolio with a target asset allocation. Investors often begin with an initial allocation based on factors such as risk tolerance, financial situation, investing goals, and time horizon.

For example, an investor may start with a target asset allocation of:

• 60% equities

• 40% bonds

Over time, the relative performance of these asset classes may shift the portfolio away from that mix. If equities rise more quickly than bonds, the portfolio could become:

• 70% equities

• 30% bonds

At that point, the investor may choose to rebalance by reducing exposure to the overweighted asset classes and increasing exposure to the underweighted ones.

Portfolio rebalancing can involve several types of investments, including:

• Canadian equities

• US stocks

• Foreign stocks

• Bonds

• Exchange-traded funds (ETFs)

• Cash holdings

The process may happen on a schedule, such as quarterly or annually, or only when the portfolio moves beyond a certain threshold.

Why Asset Allocation Changes Over Time

Asset allocation is rarely static because markets do not move uniformly. Different asset classes can perform differently during changing economic and market conditions.

For example:

• Equities may rise during periods of economic growth

• Bonds may perform differently when interest rates change

• Foreign stocks may react to currency movements or regional events

• Defensive assets may behave differently during periods of volatility

As a result, an investment portfolio can gradually drift away from its desired asset allocation.

This drift may increase or reduce portfolio risk depending on which assets become overweighted. A portfolio that was originally aligned with a moderate risk profile could become more heavily concentrated in equities after a prolonged stock market rally.

Portfolio rebalancing is often used to bring the asset mix closer to the investor’s original allocation.

Does Portfolio Rebalancing Actually Improve Returns?

The relationship between portfolio rebalancing and returns can be complex. In some environments, rebalancing may support more stable long-term returns by controlling portfolio risk. In other situations, a portfolio that remains untouched could experience stronger growth if one asset class continues to outperform for an extended period.

Whether portfolio rebalancing actually improves returns may depend on several variables, including:

• Market conditions

• Volatility levels

• The types of asset classes involved

• Frequency of rebalancing

• Transaction costs

• Capital gains taxes

• Investor behaviour

One commonly discussed feature of rebalancing is that it may involve selling assets after periods of stronger performance and adding to assets after weaker performance. Some investors view this as a disciplined process that maintains a target asset allocation rather than reacting emotionally to market movements.

However, rebalancing can also reduce exposure to asset classes that continue rising. During sustained bull markets, an unrebalanced portfolio with a larger allocation to equities could potentially produce higher future returns than a rebalanced portfolio.

As a result, portfolio rebalancing is often associated more closely with managing risk and maintaining consistency than with maximizing returns alone.

How Rebalancing May Affect Risk

Risk management is one of the most common reasons investors rebalance their portfolios.

As market movements shift a portfolio’s asset mix, the level of risk exposure may also change. For example, a portfolio heavily weighted toward equities could experience larger swings in value during periods of volatility.

By restoring a target allocation, rebalancing may help align the investment portfolio with the investor’s intended risk tolerance.

This can be especially relevant during different market cycles:

During Strong Equity Markets

When equities outperform bonds or cash, stock allocations can grow beyond the original target asset allocation. Rebalancing may reduce concentration risk by trimming overweighted asset classes.

During Market Declines

In weaker markets, equities may decline while bonds or cash remain more stable. Rebalancing could involve adding to equities to restore the portfolio’s original allocation.

During Volatile Periods

Frequent changes in market conditions can shift portfolio weights more rapidly. Rebalancing may help maintain a more consistent risk profile through changing conditions.

For some investors, maintaining a consistent level of risk exposure may be just as important as focusing on future returns.

Different Approaches to Portfolio Rebalancing

There is no single method for portfolio rebalancing. Investors and portfolio managers may use different approaches depending on investment objectives, account types, and personal preferences.

Calendar-Based Rebalancing

This approach involves reviewing the portfolio at set intervals, such as:

• Monthly

• Quarterly

• Semi-annually

• Annually

The portfolio is adjusted at those times regardless of market conditions.

Threshold-Based Rebalancing

With this method, the portfolio is only rebalanced when an asset class moves beyond a predetermined percentage range.

For example, an investor with a 60% equity allocation may rebalance only if equities rise above 65% or fall below 55%.

Combination Approaches

Some investors combine both methods by reviewing the portfolio periodically while also monitoring for larger allocation changes.

Each method can produce different outcomes depending on market behavior and the frequency of adjustments.

The Role of Different Asset Classes

Portfolio rebalancing often works differently depending on the asset classes involved.

Equities

Equities can experience higher volatility and stronger long-term growth potential compared with more defensive assets. A portfolio concentrated heavily in equities may drift more quickly during strong market periods.

Bonds

Bonds may provide stability or income within a diversified investment portfolio. Their performance can differ from equities during changing economic conditions or interest rate environments.

Foreign Stocks

Foreign stocks may introduce geographic diversification, but they can also be influenced by currency fluctuations and regional economic trends.

Cash and Short-Term Investments

Cash holdings can provide liquidity and may reduce overall volatility, though they may also affect long-term growth potential.

The relationship between these asset classes may influence how often a portfolio requires rebalancing and how rebalancing affects long-term returns.

Frequent Portfolio Rebalancing Vs Less Frequent Adjustments

The frequency of portfolio rebalancing can influence both costs and outcomes.

Frequent Portfolio Rebalancing

More frequent adjustments may:

• Keep the portfolio closer to its target allocation

• Reduce allocation drift

• Increase trading activity

• Create higher transaction costs

• Trigger additional capital gains taxes in taxable accounts

Frequent trading may also reduce flexibility during periods of market momentum.

Less Frequent Rebalancing

Less frequent portfolio rebalancing may:

• Reduce transaction costs

• Allow asset classes to run longer during strong market periods

• Lead to larger shifts in portfolio risk over time

• Result in wider deviations from the desired asset allocation

There may be a trade-off between maintaining allocation consistency and minimizing costs.

Tax Considerations and Taxable Accounts

Taxes can play a role in rebalancing decisions, particularly in taxable accounts.

Selling investments that have increased in value may trigger capital gains taxes. Depending on the size of the gains and the investor’s financial situation, these taxes could affect after-tax returns.

Some investors use approaches that may support more tax-efficient rebalancing, including:

• Using new contributions to add to underweighted asset classes

• Rebalancing within registered accounts when possible

• Applying tax-loss harvesting techniques during market declines, selling securities at a loss to offset capital gains elsewhere in the portfolio. Note that the Canada Revenue Agency's superficial loss rule may deny the loss if the same or an identical security is repurchased within 30 days before or after the sale. In those cases, the denied loss is added to the adjusted cost base of the repurchased security rather than being immediately deductible. 

Tax considerations may become more significant for investors with larger portfolios or those holding investments over long periods.

Portfolio Rebalancing and Market Timing

Portfolio rebalancing is sometimes compared with market timing, though the two approaches generally involve different goals.

Market timing often attempts to predict short-term market movements by increasing or reducing exposure based on expected future conditions.

Portfolio rebalancing, by comparison, usually focuses on restoring a target asset allocation after market movements have already occurred.

For example:

• After strong equity gains, rebalancing may involve reducing equity exposure

• After market declines, rebalancing may involve increasing equity exposure

Some investors view this process as a rules-based framework that enforces discipline rather than relying on predictions about future returns.

How Rebalancing May Influence Investor Behaviour

Investor behaviour can influence investing success over time, especially during periods of volatility or uncertainty.

Large market swings may create emotional reactions that affect decision-making. Portfolio rebalancing may help reduce some of these effects by providing a structured process for reviewing asset allocation.

For example, rebalancing your portfolio may:

• Encourage consistency during changing market conditions

• Reduce emotional responses to short-term market moves

• Maintain alignment with long-term investment objectives

• Reinforce a defined risk profile

Some investors also find that rebalancing helps separate portfolio decisions from short-term news or market sentiment.

Situations Where Rebalancing May Have Different Outcomes

The effect of portfolio rebalancing can vary depending on market conditions and portfolio structure.

Extended Bull Markets

In prolonged equity rallies, an unrebalanced portfolio with a growing allocation to equities may produce stronger gains than a rebalanced portfolio.

Sideways or Volatile Markets

During periods of volatility or range-bound markets, rebalancing may help capture shifts between asset classes while maintaining consistent risk exposure.

Diversified Portfolios

Portfolios containing multiple asset classes with different performance patterns may experience more opportunities for rebalancing than portfolios concentrated in a single asset category.

Concentrated Portfolios

Portfolios focused heavily on one sector or asset class may experience larger allocation swings, which could increase the role of rebalancing in managing risk.

Different market cycles may produce different outcomes for both rebalanced and unrebalanced portfolios.

Common Challenges With Portfolio Rebalancing

Although portfolio rebalancing can support allocation management, there can also be challenges.

Transaction Costs

Buying and selling investments may create fees, spreads, or commissions depending on the account and investment type.

Taxes

Capital gains taxes in taxable accounts may reduce net returns after rebalancing transactions.

Emotional Decision-Making

Rebalancing can involve selling investments that have recently performed well or adding to underperforming assets, which some investors may find difficult during periods of strong market momentum.

Overtrading

Frequent portfolio rebalancing could increase trading activity without materially changing long-term outcomes.

Rebalancing and Long-Term Investing

Portfolio rebalancing is often discussed within the context of long-term investing.

Over extended periods, market fluctuations can substantially alter an investment portfolio’s asset mix. Rebalancing may help maintain alignment between the portfolio and the investor’s original objectives, risk tolerance, and time horizon.

At the same time, long-term returns are influenced by many factors beyond rebalancing alone, including:

• Asset allocation choices

• Diversification

• Market conditions

• Investment costs

• Tax considerations

• Savings rate and contribution behaviour 

• Investor behaviour

As a result, portfolio rebalancing is typically viewed as one component of portfolio management rather than a standalone factor driving investing success.

How Investors Monitor a Rebalanced Portfolio

Maintaining a rebalanced portfolio may involve periodic reviews of:

• Asset allocation

• Portfolio drift

• Relative performance

• Risk exposure

• Investment objectives

• Changes in financial situation

• Time horizon adjustments

Some investors review portfolios manually, while others use automated tools or professionally managed accounts that monitor target allocation ranges automatically.

The level of monitoring can vary depending on portfolio complexity and account structure. Regardless of the method used, the goal is generally the same: to ensure the portfolio continues to reflect the investor's current risk tolerance, time horizon, and financial objectives.

Final Thoughts on Portfolio Rebalancing and Returns

Portfolio rebalancing plays a role in maintaining a target asset allocation as market conditions change over time. While a rebalanced portfolio may support risk management and portfolio consistency, its effect on long-term returns can vary across different market cycles and asset classes. Factors such as transaction costs, capital gains taxes, volatility, and rebalancing frequency may also influence outcomes. For many investors, portfolio rebalancing is less focused on predicting future returns and more connected to maintaining a desired asset mix and risk profile. As with most portfolio decisions, the relevance of rebalancing can depend on investment objectives, time horizon, and overall financial situation.