[Disclaimer: These are my own views, not financial advice. Use at your own risk.]

Looking back at Part 3: Asset Allocation, if you invested $100 each month using an asset allocation of 35% domestic stock (VTI), 15% international (VXUS), 40% bonds (BND) and 10% cash, your portfolio’s asset ratio would drift over 10 years to about 39% / 16% / 37% / 8%. This means it became more aggressive over time (more stocks, fewer bonds). This makes sense, since you’d expect the most aggressive part of your investments to grow faster, taking a larger share of your portfolio over time. This increasingly risky portfolio is probably not what you want.

This is where portfolio rebalancing comes in. The general guidance is to pick a fixed period (say, yearly) and rebalance your portfolio to your desired asset allocation – sell investments that exceed their target allocation and buy those that fall below. This is called static rebalancing. You can also monitor allocations and trigger a rebalance when they deviate too much (say, by more than 20% of your target) – this requires a more hands-on approach and is called threshold rebalancing.

What’s the catch? Taxes, once again. Unless your investing in a 401K or tax-deferred account, whenever you sell shares above your desired allocation, you’ll pay capital gains taxes on the profit. If you’re trying to manage your tax bill, consider dynamic rebalancing.

Dynamic rebalancing reduces drift along the way – avoiding the need for big sell-offs. The concept is simple: each month buy only funds that are below their target to bring your portfolio back in line. For example, instead of spending $100 x 35% = $35 on domestic stock, you might spend less – or nothing – and put the rest into bonds. This approach keeps your asset allocation close to target over the 10-year period, so fewer funds need to be sold during rebalancing.

Here’s the math

• Target = (Portfolio + New Investment) x Asset Allocation % -> ($1,000 + $100) x 35% = $385 (target domestic stock).
• Current = $370 (pretend it’s $370 based on market price and how much you own).
• Buy = ($385 – $370) = $15 of domestic stock.

Repeat for international and bonds. The total should equal $100. If over, cap at $100. If under, skip the rest.

Some drift will occur, so periodic rebalancing is still needed – but it’s less severe. And because fewer sales are needed, you pay less in capital gains tax – allowing more of your money to compound (you’re deferring taxes, not avoiding them).

So what’s the catch? If stocks only rise, static yearly rebalancing outperforms dynamic rebalancing in returns – even after taxes (though this depends greatly on your tax situation). The reason is simple: you’re letting your biggest gainers take a larger share for longer. In other words, you’re exposing your portfolio to more risk targeted – unwittingly trading gains for risk.

But markets don’t rise smoothly – they fluctuate, and that’s where dynamic rebalancing shines. When stocks are down, you buy more – not only because they’re cheaper (your $100 allocation stretches further), but because that asset class is under target (so a larger share of the $100 goes there) – doubling down on “buy low”. In a fluctuating market, returns from both methods are similar. The main benefits of dynamic rebalancing are:

• Your asset allocation (and risk profile) stays closer adhered to target (less unintended risk).
• You defer capital gains taxes until liquidation (possibly in a lower tax bracket).

My advice? Do whichever method works for you. If dynamic rebalancing is easy, do that. I use an Excel spreadsheet that tells me exactly what to buy – no fuss, no mistakes. But if you’re unsure or it seems complicated, use the old-fashioned way – you’ll still be On-Rails!

Good luck!

-Gary

Some helpful resources:

• Vanguard, Rebalancing your portfolio: https://investor.vanguard.com/investor-resources-education/portfolio-management/rebalancing-your-portfolio