How to think about portfolio rebalancing?

Portfolio rebalancing is an essential portfolio maintenance operation (learn more about rebalancing).

I hear that many investors don’t regularly rebalance their portfolios because rebalancing means booking profits—and booking profits means paying taxes. Rebalancing is also counterintuitive because rebalancing is trimming down exposure to assets that have done well in the recent past and increasing exposure to assets that have not done as well. No one wants to sell their winners to buy more of their losers.

I think such a hesitation to rebalance stems from a lack of understanding. Rather than looking at the portfolio as one unit, the investor likely looks at different asset classes in the portfolio as independent assets.

Think of an investment portfolio with 3 different asset classes. This could be equity + bonds + gold, but it doesn’t really matter which specific assets. A portfolio that contains these assets is like a stool with 3 legs. When one leg grows too tall or shrinks too short, the stool loses balance and collapses. When one asset in the portfolio has an outsized growth or a big fall, your portfolio loses balance.

“Stool” by an unidentified maker from rawpixel.com; licensed under CC0

But stools are a poor analogy. Every stool needs legs that are of equal height, but portfolio assets are often mixed in different proportions. If you don’t like to visualise your portfolio assets as legs of a stool, maybe think of the portfolio as a primitive aeroplane that is balanced using weights attached to its sides. What happens when one weight becomes too heavy or too light? The whole plane loses balance and can fall down. Regularly assessing and readjusting the weights to keep them in the right proportion is crucial to keep the plane stable and flying.

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Using such a mental model helps in 2 ways:

1. It enables us to see the portfolio as one entity rather than as a collection of independent entities.
2. It makes rebalancing less painful, and possibly even satisfying, because your focus is shifted from individual assets or tax bill over to the stability of your portfolio.

Both of these can contribute positively to investing success.