Rebalancing

Drift: the portfolio you chose stops being the portfolio you own

Set a 60/40 portfolio and walk away, and markets will quietly rewrite it. After a few strong years for stocks, the 60/40 becomes 70/30, then 75/25, not because you decided anything but because the winners grew. That drifted portfolio is a materially riskier one than you chose: the next crash will hit a 75/25 much harder than the 60/40 you signed up for.

Drift is sneakiest in good times. The portfolio getting riskier is also the portfolio going up, so nothing feels wrong until the moment everything does. Rebalancing is the maintenance habit that keeps your asset allocation an actual decision rather than an accident of recent returns.

Why it feels wrong and works anyway

Rebalancing means selling whatever has been performing best to buy whatever has been disappointing, which is exactly backwards to every instinct. Nobody enjoys trimming a soaring stock fund to buy more bonds. But followed mechanically, the rule forces you to buy low and sell high on a schedule, with no forecasting and no feelings involved.

Be honest about what it is for, though. Rebalancing is primarily risk control, not return enhancement. Some years it adds a little return, other years trimming your winners costs a little, and over long periods the effect on returns is modest either way. What it reliably delivers is a portfolio whose risk stays at the level you deliberately chose, which is what lets you hold on through the next crash.

Three ways to do it

There are three standard methods, and none requires watching markets.

• Calendar rebalancing. Pick a date, once a year, and restore targets then. Annually is plenty; more frequent rebalancing adds effort and trading without adding much benefit.
• Threshold rebalancing. Act only when an asset class drifts 5 or more percentage points from target, say a 60% stock target reaching 65%. Nothing to do most years, decisive action after big moves.
• Cash-flow rebalancing. Direct new contributions and dividends to whatever is underweight, so the portfolio pulls back toward target without selling anything. For anyone still contributing regularly, this does most of the job by itself, and it is the tax-free method.

The tax angle: where you rebalance matters

Inside a TFSA or RRSP, rebalancing is tax-free: sell and buy whatever the targets require, and no tax consequence follows. Rebalance freely there.

In a non-registered account, selling winners is a taxable event that realizes capital gains tax. Rebalancing is still worth doing, but the method changes: prefer cash-flow rebalancing, steering new money and distributions to the underweight side so you rarely need to sell, and when selling is unavoidable, do as much of it as possible inside registered accounts, since your targets apply to the whole portfolio rather than to each account separately.

Or let it happen automatically

Asset allocation ETFs rebalance themselves internally, which is a large part of their appeal: one fund, permanently on target, no discipline required. A robo-advisor does the same across a portfolio of separate funds, monitoring drift and trading back to target for you. If you know you will never actually do the annual chore, buying the automation is a perfectly good answer.