Christmas is fast approaching, which means it’s the perfect time of year to take a break from not worrying about investing at all. Between shopping for gifts, sipping warm beverages, and binge watching cozy holiday movies (yes, Die Hard counts), this is when I also set aside some time to think about the annual investing ritual of rebalancing my portfolio.
Some years that’s easy, when asset percentages haven’t moved much you can just leave things alone and move on. And others are more complicated. With crazy gold gains this year necessitating a big sale and a potentially sizable tax bill, this year definitely qualifies as the latter.
First world problems, I know. 🙂
Well, I just finished my own rebalance and have also received quite a few emails recently asking about the same topic. So while it’s fresh on my own mind and possibly yours, too, let’s talk a bit about the art and science of how to rebalance a portfolio.
Why Rebalance a Portfolio?
Before we dive into the nitty gritty details, I think it makes sense to first start with the basics.
What is rebalancing, and why is it important?
Whenever you divide your money between more than one asset, the initial percentages are just a snapshot in time. Since markets are dynamic, the percentages of each asset will change on a daily basis. So if you invest in the Classic 60-40 Portfolio of 60% stocks and 40% bonds, the initial 60/40 split will immediately change with stock and bond performance.
On a daily basis it’s nothing to worry about. But over time, that drift can add up. Take for example the wild ride of 2008 when stocks were down 37% (adjusted for inflation) and bonds were up 15% A perfectly balanced 60/40 portfolio in January was more like 45/55 in December. Or on the other extreme, consider 2013 when stocks were up 33% and bonds were down 3%. The same perfectly balanced 60/40 portfolio was 67/33 by the end of the year.
Most investors intuitively recognize that a portfolio with 45% stocks probably has a different expected return and risk profile from one with 67% stocks. And neither have the same performance characteristics of the original 60/40 portfolio you chose for a reason.
So how do we fix that? By rebalancing.
Rebalancing a portfolio is simply the process of moving money around between assets to get back to your target percentages. Usually that means selling the ones above their target percentage to buy more of the ones below their target percentage.
We do this for two reasons.
First, rebalancing helps to maintain the target portfolio performance that you need from your investments. For reference, all calculations on Portfolio Charts assume that you rebalance back to the target percentages every year. So following that same system prevents your portfolio from drifting into more risk or less returns than you signed up for.
Second, the act of regular rebalancing has a positive direct effect on the risk-adjusted returns in a portfolio. Sometimes called the “rebalancing bonus” this phenomenon is an important part of how diversified portfolios work to generate unexpectedly high returns with minimum drawdowns. For lots more information on now that works, check out my article on Shannon’s Demon. But the simplest explanation is that selling high and buying low really does help portfolio even with simple annual rebalancing and no active management required.
While it may be very tempting to “let winners ride” or emotionally difficult to buy more of a beaten-down asset, getting into the habit of regular rebalancing is an important way to divorce yourself from the emotions of the market ride and to stick with a real plan. You’ll maintain your target performance, improve your risk-adjusted returns, and generally keep the right mindset necessary to succeed in the long run.
Rebalancing our portfolios keeps investors balanced as well.
Tax Minimization Strategies
While the idea of rebalancing is quite simple, the execution can quickly become a bit intimidating. The reason for that is one very important thing we all have to account for — taxes. Selling assets for a profit generates capital gains, and capital gains can generate sizable tax bills if you’re not careful.
Taxes are extremely complicated, and in a setting like this where I write for a global audience it’s impossible to account for every single situation. So I’ll stipulate right from the start that I write from the perspective of a US investor. Depending on where you live, not every point may apply to you. But I’m also going to try to include enough universal ideas that you can hopefully pick and choose a few that may help.
In that spirit of picking and choosing, I present to you a few of my own thoughts that I progressed through in my recent rebalance in a menu-like list form instead of a pure narrative. Use what makes sense, and ignore what does not apply.
Focus on taxable accounts
The first step in thinking about taxes is to focus on the accounts that matter. We have a few tax-deferred IRA and 401k accounts where the returns are tax-free, and rebalancing those are no worry at all. But our joint taxable account is another matter, and every sale must be carefully considered to evaluate the tax impact ahead of time.
Top up lagging assets with new money
For people in the accumulation phase, the single best way to tax-efficiently rebalance your portfolio is to apply any new savings towards assets that are below their target percentages. You don’t need to sell a thing, so there’s no tax impact at all.
Early on in your accumulation, there’s a good chance that new contributions are large relative to your investing returns. As a result, you may go years without ever having to sell (and pay the associated capital gains taxes) at all. But as your investments grow, those magical compound returns start to kick in and your work income will become a smaller percentage of your total gains for the year. That’s when you’ll need to be more thoughtful about tax planning. And the good news is that you’ll have many years to learn and prepare.
This year our investing gains dwarfed our modest outside income, so simply buying the lagging assets with new money isn’t enough to properly rebalance. But many of you can stop here and be just fine.
Turn off automatic dividend & interest reinvestment
One feature in modern trading platforms that is often turned on by default is automatic reinvestment of dividends and interest. That’s great from a set-it-and-forget-it mindset, but for tax planning it’s less than ideal. Dividends and interest are a type of forced income that are already taxed, so generating additional capital gains on the same shares to rebalance usually isn’t the best choice.
In the US, brokerages offer the option to turn off automatic reinvestment of dividends and interest and deposit them into your account as cash. That’s exactly what I do for two reasons. First, it lets me manually direct the money towards the assets below their target percentages to easily rebalance along the way. And second, it simplifies the process of tax loss harvesting by avoiding potential wash sales created by automated purchases. (More on that below).
For investors in Europe this may work a little differently, as accumulating and distributing shares are handled at the fund level and not the brokerage level. So I’m not sure if this completely applies to you or if there are other tradeoffs involved as well. But I imagine thinking about how you will handle dividends and interest is a good practice for every investor.
Understand capital gains
When selling an asset, the thing that matters most is the capital gain. You’re not taxed on the full current price of the sale, but on the gain over and above the original share price (known as the cost basis) that you paid for the security.
This concept is not that tricky, but it can admittedly take some practice to fully understand. Here’s a simplified example.
Let’s say you purchased 10 shares of a stock fund at $100 a share ($1000 total). After a few great years, it is now worth $200 a share, or $2000 total. You decide to sell half of your shares (5 shares now valued at $1000) to get back to a $1000 allocation to the fund.
What is your capital gain?
The answer is not $1000, even though you just sold $1000 in stock. Instead, it’s $500. You can calculate that by looking at the gain per share from your original purchase price and multiplying that gain per share by the shares sold. So (200-100) * 5 = $500. That’s your taxable capital gain.
When evaluating capital gains, it’s critical to look at the specific shares you’re selling. Depending on when you purchased them, some may have much more gains than others. Selecting the specific shares to sell (rather than just relying on your default brokerage setting (like first-in-first-out) can have a big effect on your tax bill. For me, prioritizing the sale of some lower-tax gold lots saved a few thousand in taxable gains.
It’s also important to understand that capital gains taxes on the same sale vary based on several different factors. Gains on stocks and bonds held less than a year are taxed as ordinary income, while they have preferential tax brackets as low as 0% once you hold them for at least one year. When in doubt, always sell assets held for at least one year for the best tax treatment.
My situation this year was a little more unique, as I had big gold gains. My target Golden Butterfly gold allocation is 20%, while my actual portfolio percentage crept all the way up to near 30%. And gold is unique in the US in that is taxed not like a stock or bond, but as a collectible. That means that capital gains on gold are taxed as ordinary income with a cap of 28%. So I had to be extra careful.
Utilize tax loss harvesting
While capital gains taxes can seem unavoidable on the surface, the IRS grants taxpayers a terrific way to minimize the impact. Capital gains in one asset can be directly offset by capital losses in another. So if you have big gains in gold but sold other stocks or bonds at a loss, you can offset the gains dollar for dollar with those losses. Intentionally generating losses to offset gains is a process called tax loss harvesting.
Since the entire purpose of rebalancing is to sell high and buy low, the idea of selling assets low can seem pretty counter-intuitive. But that doesn’t mean you have to depart for your target portfolio percentages even further. Instead, it’s perfectly acceptable to sell a fund at a loss and either wait one month to repurchase it or immediately purchase a similar-but-different fund that tracks the same asset class.
The process of tax loss harvesting is a topic worth of its own discussion. For more info, including a list of fund pairs to avoid wash sales, check out this writeup:
While we’re here, this is a good time to talk about another strategy called tax gain harvesting. Depending on your personal tax bracket, it may actually make sense to sell shares with the highest gains. For example, if the long term capital gains rate for your household income is zero even after the sale, then it’s better sell the shares with higher gains and save the ones with lower gains for later.
Based on the specific timing of my own index fund purchases over the years, I had a few small tax losses to offset a few thousand dollars of gold gains, but not nearly enough to offset them all. Tax gain harvesting was also not a consideration. So on to the next step.
Understand tax brackets
The part where taxes get really confusing is once you start to dig into tax brackets. Depending on your family size, filing status, total income, and even the type of income, not every dollar is taxed at the same rate. Trying to delve into every possible tax permutation in an article like this is an impossible task. But there are 2-3 thresholds that I think most US investors should think about. The main ones are your ordinary income and capital gains tax brackets. And if you buy health insurance on the ACA exchange, you’ll also want to pay special attention to the 400% FPL subsidy cutoff amount that kicks in next year.
Precisely calculating each bracket for your personal situation is beyond the scope of this article. If you need help, creating a dummy return in tax software like TurboTax is a great sanity check and consulting a tax professional is also a fine choice. But here’s how I think once I have the numbers I need.
The gains from gold sales count towards ordinary income, so I paid particular attention to the federal ordinary income tax brackets. I added up our normal income, accounted for deductions like the standard deduction and IRA contributions, and calculated the extra space we had within our best possible tax bracket. Then I made sure that the capital gains from any gold sale kept our total taxable income below that limit.
Even though that limited the rebalance to something less than the amount required to get back to a perfect 20%, being smart about it saved a good amount of taxes. It gets the gold percentage close enough to 20% that I’ll probably just leave it alone, but if I wanted to do a full rebalance I could also just perform the rest of it in January in the new tax year. New year, new space in the better tax brackets.
Consider trading bands
That last point about not necessarily fully rebalancing every year like a robot is important enough that it’s worth repeating. Being smart about tax management is just as important as being smart about asset allocation. And sometimes it makes sense to do just a partial rebalance or even no rebalance at all.
To minimize unnecessary but potentially costly rebalancing, some portfolio authors like Harry Browne recommend a concept called a rebalancing band. For fellow mechanical engineers out there, it’s similar to an acceptable engineering tolerance. The idea goes like this:
Asset values change all the time, and some small amount of deviation from target percentages is fine and not worth worrying about. Assume your portfolio is like the Permanent Portfolio and holds 25% of 4 different assets. Browne set his rebalancing band at +/- 10% for each asset. So if the assets are all within 15-35% of the total portfolio, he would consider that “close enough” and leave it alone. But if any one asset exceeded those bands, he would take that as a signal to rebalance the entire portfolio.
Personally, I don’t use hard trading bands with my own portfolio, preferring to rebalance when I can tax-efficiently. But the mindset is certainly helpful in the years when I choose to do nothing. Give yourself permission to leave things alone, and you’ll reduce your tax paid most years while still taking action when it is needed.
Putting It All Together
I understand this is a lot to think about, and I also know that I didn’t even get into the full details in every situation. Taxes are complicated.
Talking about tax planning can also get pretty dry and theoretical, with most people just avoiding details and advising people to see a professional. So I thought I’d do something a little different and summarize my own recent rebalancing steps.
Tyler’s 2025 Rebalancing Process
- I set all dividends and income throughout the year to go into our brokerage cash account. So they are not automatically reinvested, and I allocated the cash into other assets as part of the normal rebalancing process.
- I always look at rebalancing after Thanksgiving to figure out what makes sense by the end of the year. In our tax-deferred IRAs, I just rebalanced fully with no worry by selling the assets above their target percentage to buy more of the ones below their target percentage. And I then turned my attention to the taxable brokerage account.
- I started by estimating our total income for the year including not only work income but also dividends and interest from the stocks and bonds in our portfolio. That helped me understand the space I had to work with in a preferable tax bracket.
- I made a spreadsheet that calculates the current percentages of each asset, the target percentages after a rebalance, and the necessary sales to make that happen. I also figured out the capital gains from any sale using the cost basis from my brokerage records. There were no opportunities for tax loss harvesting to offset gains, so I paid careful attention to how the additional income affected our tax brackets.
- With that info, I looked at what I needed to accomplish to rebalance. Stocks were a little above their target, but not as much as gold. So I focused on rebalancing gold, and figured out the amount that I could safely sell while keeping our total ordinary income (remember, gold does not get preferable capital gains tax rates) below the cutoff for the higher tax bracket. I wasn’t able to get the gold allocation down to a perfect 20%, but it’s close enough that it’s still a great improvement without paying more taxes than necessary.
- After the gold sale, I used the proceeds along with the accumulated cash from dividends and interest to top off the small cap value stocks and long term bonds in my portfolio to get them back to their 20% target allocations. And the remainder went into short term bonds. Since it’s not a full rebalance, that’s the asset I’m ok with keeping a little below its target percentage for now.
The end result from all this work is a mostly-rebalanced portfolio, with percentages within a normal rebalancing band tolerance and minimum taxes paid. Even in a banner year for a tricky tax asset like gold.
Of course, everyone is different. Much of what applies to me may not apply to you. So I share this not as a template to be followed to the letter but simply as an example of how the thought process works.
Despite the complexity, the message I hope people take away is not that taxes are scary but that smart rebalancing is totally doable by normal people like you and me. I get emails all the time from investors excited about diversification but intimidated by the tax side of rebalancing or spooked by an article about gold taxes that doesn’t even explain it properly. I’m here to tell you that it will be ok. Sure, it may take some practice to get the hang of it, and you may need to seek help to get you started. But it’s worth it!
Rebalancing a portfolio is an important part of how smart asset allocation works. One you get in the habit and have a few years under your belt, it gets a lot easier and will become a normal routine. The beauty of the simple asset allocation philosophy I follow and talk about is that touching your portfolio just once a year is so much simpler than complex continuous trading strategies.
Learn how it works, and you’ll be able to close your annual rebalance with confidence and go right back to your favorite Christmas movie.
Happy Holidays!
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