An asset allocation balances investment risk and return by specifying a particular mix of investments based on the investor’s risk tolerance. For example, an investor might decide to invest 60% of their portfolio in stocks, 30% in bonds and 10% in cash. Investment risk tends to increase as the return on investment increases. Investors can manage the risk of their investment portfolio by combining high-risk investments with low-risk investments.

As the investments change in value, however, the mix of investments may drift away from the original asset allocation. This creates a need to rebalance the investment portfolio by selling some investments and buying others. Otherwise, the growth in value of riskier investments might yield more risk than the investor is willing to tolerate.

Advantages of Rebalancing

Part of the purpose of an asset allocation is to dilute the impact of each asset class by limiting both the upside and downside impact of the investments. But, when a particular investment grows in value faster than the other investments, you are exposed to more risk than you originally intended. Rebalancing your portfolio returns your investments to your original risk tolerance and reduces the risk that your portfolio will drop in value.

Rebalancing a portfolio also improves diversification. When one stock grows significantly in value, the portfolio becomes weighted more heavily toward that stock, magnifying the impact of that stock on overall portfolio performance.

For example, suppose you invested $10,000 in Tesla TSLA , Inc. (TSLA) on April 1, 2020, when it was about $100 a share, and $10,000 in Intel Corporation INTC (INTC) when it was about $50 a share. (Figures are rounded to simplify this example.) You would own 100 shares of TSLA and 200 shares of INTC. On April 1, 2021, TSLA reached about $688 a share and INTC reached about $65 a share. Your TSLA shares would be worth $68,800 and your INTC shares would be worth $13,000. Your investment in TSLA would have grown from half of your portfolio to more than 80% of your portfolio.

Rebalancing also avoids the potential for emotions to interfere with your buy and sell decisions. It is hard to follow the advice to buy low and sell high when it means selling winners to buy losers. There can also be some resistance to selling a stock with a lot of gains in a taxable account. (This is why rebalancing is easier in retirement plan accounts, where the investor doesn’t have to pay taxes on capital gains.)

Rebalancing is also a natural consequence of investment glide paths that change the asset allocation over time, such as target date funds. These investment glide paths reduce the risk mix of a portfolio as the target date approaches. An example of a linear glide path is the old rule of thumb that the percentage invested in stocks should be 100 minus your age. It reduces the risk mix of the portfolio as retirement age approaches. Implementing an investment glide path requires rebalancing the portfolio periodically.

Disadvantages of Rebalancing

But, why would you sell investments that are doing well to buy investments that aren’t doing well?

Continuing the previous example, by November 1, 2021, TSLA stock had risen to $1,145 a share and INTC stock had dropped to about $49 a share. If you had rebalanced your portfolio on April 1, 2021, your portfolio would be worth $98,899 on November 1, 2021, about a fifth less than the $124,300 it would have been worth if you hadn’t rebalanced. The portfolio is worth more than the $81,800 the portfolio was worth back in April, but not as much as it might have been worth without rebalancing.

Rebalancing is an uninformed strategy that assumes that high-flying investments have nowhere to go but down or, at best, have no room for further growth. In the case of TSLA stock, it assumes that the investment will drop in value because it has come so far so fast. It argues that rebalancing the portfolio is necessary to protect it from a decrease in value.

But, past performance does not predict future results. Rebalancing is just as guilty of basing investment decisions on past performance as momentum plays, whether the rebalancing occurs on a schedule or upon a specified level of divergence from the target asset allocation. It is a pessimistic form of market timing, which is often less effective than remaining invested.

Rebalancing assumes that stocks are more likely to decrease in value when their value has increased, which is not necessarily true. It also assumes that low-performing investments are hidden gems that will increase in value, without any evidence to support the assumption. When an investment has been demonstrating lackluster performance, there is no reason to expect that it won’t continue to demonstrate poor performance. Sometimes, a stock is a low performer for a reason, in which case rebalancing is unlikely to improve the results.

Rebalancing also conflicts with other common strategies, such as buy-and-hold and harvesting losses to offset capital gains.

The decision to rebalance should be forward-looking, based on expectations about where the stock and bond markets will head in the future. You should sell an investment when your reasons for buying the investment are no longer valid, not because the investment is performing as expected.

For example, selling stocks now to buy bonds is problematic because bonds are likely to decrease in value when the Federal Reserve Board increases interest rates. Interest rates and bond prices usually move in opposite directions. Selling an investment that is expected to increase in value to buy one that is expected to decrease in value is a recipe for losing money.

Returning to the INTC and TSLA example, both stocks are affected by demand for their products exceeding supply, but there is no reason to expect INTC to outperform TSLA. Certainly, the market dominance of Tesla vehicles has eliminated an incentive for Tesla to add certain features that consumers want, such as heads-up displays (HUD) and digital rear-view mirrors. But, Tesla does not face a shortage of demand for its vehicles. Both INTC and TSLA are limited by how quickly they can ramp up production capacity to meet demand.

Rebalancing works well when an investment is volatile, going up and down frequently, especially when the gains and losses are out of sync with other investments. Rebalancing does not work well when one investment consistently outperforms the other investments.

Rebalancing may not be necessary if you have a long investment time horizon, which gives you time to recover from short-term losses.

Rebalancing also increases costs due to transaction charges from buying and selling frequently. In addition to incurring more fees, rebalancing also yields higher taxes from realizing capital gains.

A possible alternative to rebalancing based on percentages is to rebalance based on the original amount invested in each asset class, perhaps adjusted for inflation. That way, the original amount invested retains the same risk profile and can act as a safety net. Gains beyond the original investment are just icing on the cake.