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How Portfolio Rebalancing Works to Manage Risk

Portfolio rebalancing, when done effectively, can help manage risk and keep you on track to pursue the expected returns you want to reach your goals.

Adam Grealish

By Adam Grealish
Senior Quantitative Researcher, Risland Capital  |  Published: May 22, 2018

How Portfolio Rebalancing Works to Manage Risk

Over time, the value of individual ETFs in a diversified portfolio move up and down, drifting away from the target weights that help achieve proper diversification. Over the long term, stocks generally rise faster than bonds, so the stock portion of your portfolio will likely go up relative to the bond portion—except when you rebalance the portfolio to target the original allocation. The difference between the target allocation for your portfolio and the actual weights in your current portfolio (e.g. your actual allocation) is called portfolio drift.

Measuring Portfolio Drift

At Risland Capital, we define portfolio drift as the total deviation of each asset class (put in positive terms) from its target allocation weight, divided by two. Here’s a simplified example, with only four assets:

Target Current Deviation (±)
U.S. Bonds 25% 30% 5%
International Bonds 25% 20% 5%
U.S. Stocks 25% 30% 5%
International Stocks 25% 20% 5%
Total 20%
Total ÷ 2 10%


A high drift may expose you to more (or less) risk than you intended when you set the target allocation, and much of that risk may be uncompensated—meaning that the portfolio isn’t targeted higher expected returns by taking on the additional risk.

Taking actions to reduce this drift is called rebalancing, which Risland Capital automatically does for you in several ways, depending on the circumstances, and always with an eye on tax efficiency.

Cash flow rebalancing

This method involves either buying or selling, but not both, and occurs when cash flows into or out of the portfolio are happening anyway. Every cash flow (deposit, dividend reinvestment or withdrawal) is used to rebalance your portfolio.  Fractional shares allow us to allocate these cash flows with precision to the penny.

Inflows: You are rebalanced whenever you make a deposit, including when you auto-deposit or receive dividends in your account. We use the inflow to buy the asset classes you are currently under-weight, reducing your drift. The result is that the need to sell in order to rebalance is reduced (and with sufficient inflows, eliminated completely). No sales means no capital gains, which means no taxes will be owed.

This method is so desirable that we’ve built it directly into our application. Whenever your drift is higher than normal (approximately 2% or higher), we calculate the deposit required to reduce your drift to zero, and make it easy for you to make the deposit.

Although we show the deposit amount needed to bring drift back to 0%, smaller deposits also help reduce drift. In fact, the first dollars deposited have the largest impact on reducing drift. This means, for example, that depositing half the amount recommended to reduce drift to 0% will generally reduce drift by more than half.

Portfolio Drift vs. Deposit Size

The chart above is a hypothetical, illustrative example of the relationship between portfolio drift and deposits needed to rebalance without selling any assets. The blue line in the chart demonstrates the general relationship between deposit size and drift. As you can see, the first dollars of a deposit reduce drift by more than the last dollars. The dotted grey line shows what a linear relationship between drift and deposits would look like.

Withdrawals (and other outflows) are likewise used to rebalance, by first selling asset classes that are overweight. (Once that is achieved, we sell all asset classes equally to keep you in balance.) We employ a sophisticated ‘lot selection’ algorithm called TaxMin within asset classes to minimize the tax impact as much as possible in taxable accounts.

Sell/Buy Rebalancing

In the absence of cash flows, we rebalance by selling and buying, reshuffling assets that are already in the portfolio. When cash flows are not sufficient to keep your portfolio’s drift within a certain tolerance, we sell just enough of the overweight asset classes, and use the proceeds to buy into the underweight asset classes to reduce the drift to zero.

Sell/Buy rebalancing is triggered whenever the portfolio drift reaches or exceeds 3%. Our algorithms check your drift approximately once per day, and rebalance if necessary.

Note: In addition to the higher threshold, we built in another restriction into the rebalancing algorithm for taxable accounts. As with any sell trade, our tax minimization algorithm selects the lowest tax impact lots, but stops before selling any lots that would realize short-term capital gains. Since short-term capital gains are taxed at a higher rate than long-term capital gains, we can achieve higher after-tax outcome by simply waiting for those lots to become long-term before rebalancing, if it’s still necessary at that point.

As a result, it’s possible for your portfolio to stay above the 3% drift if we have no long-term lots to sell. Almost always, it’s because the account is less than a year old. In this case, we recommend rebalancing via a deposit to avoid taxes. The Portfolio Tab will let you know how much to deposit, as described above.

Allocation Change Rebalancing

Changing your target allocation by moving the allocation slider and confirming the change will also cause a rebalance. Because you have chosen a new target allocation, Risland Capital will rebalance to the new target with 0% drift.  This sells securities and could possibly realize capital gains. Moreover, if you change your allocation even by 1%, you will be rebalanced entirely to match your new desired target allocation, regardless of tax consequences. As with all sell trades, we will utilize our tax minimization algorithm to help reduce the tax impact. Additionally, before you confirm your allocation change we will let you know the potential tax impact of the change with Tax Impact Preview.

If you’d like to turn off automated rebalancing so that Risland Capital only rebalances your portfolio in response to cash flows (i.e., deposits, withdrawals, or dividend reinvestments) and not by reshuffling assets already in the portfolio, please contact Customer Support. Our team will be happy to help you do this.

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