Definition
Rebalancing is a way of managing your investments by returning the mix of your assets to the original target percentages after they drift apart over time. You sell a bit of the asset whose price rose and whose share grew, and buy more of the asset whose price fell and whose share shrank, so your overall investment risk stays steady.
Why does a portfolio fall apart if you just leave it alone?
Say you're making a tasty bowl of rice and veggies, with exactly half rice and half vegetables. But the rice keeps swelling, and before you know it, 80% of the bowl is rice. The balance you first pictured is totally gone.
An investment basket (a portfolio) works the same way. At first, to keep risk low, you split your money evenly: 50% in safe bonds (basically IOUs) and 50% in stocks, which have more room to grow. But when the stock market rises a lot, only the value of your stocks keeps swelling.
Leave it alone, and stocks can climb to 70% or even 80% of all your money. With that much in stocks, a market crash hits your whole account much harder than you can handle. The safe mix you originally planned has completely collapsed.
In short, if you leave the weights alone, you end up taking more risk than you planned, without even noticing.
A mechanical rule: sell high, buy low
What many people find hardest about investing is selling what has gone up and buying more of what has gone down. When a stock is climbing, you get greedy and think it'll rise more, so you can't sell. When an asset has dropped, you get scared and start thinking about a stop-loss (selling at a loss).
Rebalancing takes the emotion out and helps you follow a good investing habit mechanically. For example, if stocks have swollen to 70%, you calmly sell the extra 20% worth of stocks and use that money to buy bonds, whose share has shrunk.
This way, you sell the stock that rose a lot at a high price and lock in a gain, and you buy more of the bond that has become relatively cheap. In other words, trimming what rose and topping up what fell happens by the rules, not by your mood. That said, the timing isn't always the exact peak or bottom, so sometimes you trim an asset that keeps rising too early and earn less.
Instead of scrambling to trade on market mood, you tidy up your account by rules you set in advance.
A bit more precisely: when and how do you do it?
If you rebalance too often, like every day or every week, trading fees and taxes pile up and can leave you worse off. So professional investors usually pick one of two clear rules and follow it regularly.
The first is the "calendar rule." You pick a set date every six months or every year and bring your mix back to where it started. It's like marking your calendar for a regular health checkup, except it's for your account.
The second is the "threshold rule." Regardless of the date, you act right away only when your mix drifts 5 or 10 percentage points or more from the original target. Setting a clear rule in advance is meant to keep losses in a downturn from growing bigger than you planned. It can't prevent losses altogether.
There's also "cash-flow rebalancing." Instead of selling anything you already own, you use new paychecks or savings each month to buy more of the asset whose share has shrunk. Since you don't sell, you can cut taxes and fees.
Common misconceptions
The main goal of rebalancing is to hit a jackpot return.
The core goal of rebalancing is "risk management." The priority is to lower the risk of a devastating loss that can come from one asset growing too large, and to bring back stability.
Where you meet it
You start with 60% stocks and 40% bonds, and after stock prices rise it's 75% and 25%. You sell some stocks and buy more bonds.
In a retirement pension account, you check your asset mix once a year and bring it back to the target you originally set.
In one sentence
Rebalancing is a check-up that returns your investment mix, thrown off by price changes, to its original target so your risk level stays as planned.