A portfolio is not a static construct. In strong market phases, the equity allocation grows all by itself, while in weaker phases it shrinks – and more defensive building blocks such as cash or bonds gain relative weight. If you do nothing, you gradually drift further and further away from your originally planned allocation. This is where rebalancing comes in: the aim is not to beat the market, but to keep your own risk profile stable using a simple, predictable system.
What rebalancing means
Rebalancing refers to periodically or event-driven resetting a portfolio to the originally desired target allocation – for example the classic 60/40 portfolio with 60% equities and 40% bonds. Anyone who has once deliberately opted for such an allocation has implicitly defined their risk tolerance. If equities rise sharply, the portfolio automatically becomes riskier; if they fall, it automatically becomes more conservative – and both happen gradually, often without the investor noticing.
Without rebalancing you bear more equity risk than originally planned during long bull markets, while after crashes the equity share may have shrunk so much that future recoveries are only participated in with a small part of the portfolio. Rebalancing systematically reverses these effects.
A konkretes Rechenbeispiel
Suppose a portfolio starts with 10,000 euros – 6,000 euros in an equity ETF and 4,000 euros in the safe part. After a strong equity year with a 20% gain in the equity part and 2% in the safe part, the total portfolio would be 11,280 euros, in which equities now account for around 63.8% and the safe part only 36.2%. The risk profile has quietly shifted. In this case, rebalancing would shift part of the equity gains into the safe component in order to move back towards 60/40.
Three basic methods at a glance
1. Time-based rebalancing
Time-based rebalancing is the simplest variant: the portfolio is reviewed at fixed intervals – once a year, half-yearly or every two to three years – and reset when there is sufficient deviation. It is easy to plan and keeps trading activity low. The downside: in very volatile years, the portfolio can deviate significantly from the target in the meantime without any intervention.
| Advantages | Disadvantages |
|---|---|
| Very simple and easy to plan | Ignores how far the portfolio drifts from the target in the meantime |
| Fits well with an annual “portfolio check-up” | In very volatile years, risk can temporarily deviate significantly from the target structure |
| Limited trading activity |
2. Threshold-based rebalancing (bandwidth model)
Threshold-based rebalancing, or the bandwidth model, combines regularity with flexibility. Here, you not only define a target allocation, but also a bandwidth within which the portfolio may move freely – for example, 55 to 65% equities for a 60% target. Only when a threshold is breached is active rebalancing carried out. This avoids unnecessary transactions in the case of small fluctuations yet still reacts when it is really necessary – though it does require regular monitoring of the percentage allocation or an appropriate tool.
| Advantages | Disadvantages |
|---|---|
| Only reacts when it is really necessary | Somewhat more complex to implement |
| Avoids unnecessary transactions in the case of small fluctuations | Requires regular monitoring of the percentage allocation or a tool that can notify you |
| Fits well with markets that experience occasional swings |
3. Rebalancing with cash flows
Rebalancing with cash flows is the most tax- and cost-efficient method: Instead of selling existing positions, new contributions are directed into the underweighted asset class. In the withdrawal phase, sales are primarily made from the overweighted asset class. Psychologically, this approach is often more comfortable because no winners need to be sold. However, this approach reaches its limits when a portfolio has become heavily unbalanced and contributions are not sufficient to fully correct it.
| Advantages | Disadvantages |
|---|---|
| More tax-efficient because fewer gains are realised | A severely unbalanced portfolio cannot always be fully corrected through cash flows alone |
| Lower transaction costs | Works better with regular and sufficiently high contributions or withdrawals |
| Psychologically more pleasant, as no winners have to be sold |
What studies show
The research is clear: A Morningstar analysis of a 60/40 portfolio found that all five rebalancing strategies examined achieved better risk-adjusted performance than a buy-and-hold portfolio without rebalancing – with a higher Sharpe ratio, a lower maximum drawdown and lower volatility. Another study from 2021 estimates that annual rebalancing can reduce volatility by a few percentage points per year in the low single-digit range while simultaneously improving returns. A Growney analysis over 15 years also shows that the effect can amount to between 0.47 and 0.86 percentage points per year in the long term – even after all costs.
Important: Rebalancing is not a return engine. In some periods it leads to slightly higher returns, in others to slightly lower ones. Its main benefit lies in more stable risk and more predictable volatility.
Which method suits which type of investor?
Anyone building wealth with ETF savings plans who wants to spend little time on financial topics and has roughly defined their risk tolerance will usually do well with an annual, fixed rebalancing date – for example always in January – combined with bands of ±5 percentage points. The system is robust, easy to implement and requires real attention only once a year.
Those who like to keep an eye on numbers anyway and want finely tuned risk management can use the bandwidth model as their main strategy and only act when a threshold is actually exceeded or undershot. For investors in the active accumulation phase, cash-flow rebalancing is a good first step – new contributions flow to where the gap to the target allocation is greatest, and sales are avoided for as long as possible.
In the withdrawal phase, the opposite logic applies: Withdrawals are preferably made from the overweighted asset class – after strong equity years, therefore from the equity component, and after weak periods more from cash or bond reserves.
Concrete example – 60/40 portfolio over ten years
A simplified thought experiment illustrates the effect: A portfolio starts with 10,000 euros in a 60/40 ratio, with equities returning an average of 6% per year and the safe component 2%. Without rebalancing, the equity share grows well above 60% over the years – the portfolio becomes riskier than the original profile suggested and falls more sharply than expected in the next bear market. With annual rebalancing, gains from the equity component are regularly and partially shifted into safer assets, and after weak years equities are systematically bought back.
In many scenarios, the average return is similar to that without rebalancing – sometimes slightly lower, sometimes slightly higher. The crucial difference does not lie in the return itself, but in the fact that risk tends to be lower and closer to what was originally chosen.
Without rebalancing
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- The equity allocation tends to grow faster
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- After ten years, the equity share is well above 60% – the portfolio has become riskier.
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- In the next bear market, the portfolio falls more sharply than would correspond to the original risk profile.
With annual rebalancing
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- Each year the allocation is reset towards 60/40
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- Equity gains are regularly and partially shifted into safer assets, and equities are repurchased after weak years.
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- In many scenarios, the average return is similar to that without rebalancing – sometimes slightly lower, sometimes slightly higher.
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- Risk (maximum losses, volatility) tends to be lower and closer to what was chosen at the beginning.
The exact difference depends heavily on the period and market development. The key point: rebalancing smooths the development of risk, not the mood of the markets.
Typical mistakes when rebalancing
1. Confusing rebalancing with market timing
Rebalancing does not mean trying to guess the right time to get in or out. It is a rules-based system, which should be implemented independently of sentiment, news flow or gut feeling.
2. Rebalancing small portfolios too frequently
Anyone with a portfolio of only a few thousand euros who pays fixed fees for each transaction can lose a significant share of returns to costs through over-frequent rebalancing. Rule of thumb: the smaller the portfolio, the less frequently active rebalancing should be undertaken – ideally using cash flows instead of sales.
3. Ignoring tax aspects
In Germany, capital gains are subject to flat-rate withholding tax. Sales carried out as part of rebalancing can realise taxable gains – at least once the saver’s allowance has been used up.
4. Failing to put the plan in writing
“I do it based on gut feeling” is not a rebalancing system. Without clear rules, a long-term strategy quickly degenerates into ad hoc market timing.
