Rebalancing

 is the action of bringing a portfolio that has deviated away from one's target asset allocation back into line. The objective is to maintain a consistent mix of asset classes (most commonly equities vs. fixed income) in order to control risk at the level desired by the investor. This is accomplished by transferring funds from higher-performing classes to lower-performing classes. While potentially counterintuitive, rebalancing ensures that investors "Buy Low" and "Sell High".

Example

 * You own two funds (Fund A and Fund B). The funds could be either mutual funds, index funds or exchange-traded funds (ETFs).
 * You have a $10,000 portfolio and have selected an asset allocation such that each fund represents 50% of the total ($5000 each)
 * Over time, Fund A rises in value to $6000 while Fund B declines in value to $4000 - you now have a 60/40 split instead of 50/50
 * To maintain your asset allocation, you would rebalance your portfolio by taking $1000 from Fund A and transferring it to Fund B
 * After doing so, your asset allocation is once again 50/50

Different rebalancing approaches
There are a variety of ways in which investors determine it is time to rebalance:
 * When a certain calendar event is reached (e.g. beginning of the year, specific day of the year, every other year, etc). For example, you might systematically rebalance your portfolio once a year, on your birthday.
 * When asset classes deviate from their target by a certain absolute percentage. For example, if your target asset allocation is 60% equities and 40% fixed income and your (absolute) rebalancing threshold is +/- 5%, you would rebalance your portfolio when your portfolio reaches (65% equities / 35% fixed income) or (55% equities / 45% fixed income).
 * When asset classes deviate from their target by a certain relative percentage. For example, if your target equities asset allocation is 60%, composed of 40% Total Stock Market and 20% Total International, and your (relative) rebalancing threshold is +/- 25%, you would rebalance International if it changes by more than +/- 5% (25% of 20%).
 * When asset classes deviate from their target by a certain dollar amount. For example, if you hold $6000 in equities and $4000 in fixed income and your rebalancing threshold is +/- $1000, you would rebalance your portfolio when either of your holdings deviates from their target asset allocation of 60% equities / 40% fixed income by at least $1000.
 * When contributing to or withdrawing from your portfolio. For example, if your target allocation is 60% equities and 40% fixed income, you hold $7000 of equities and $3000 of fixed income, and you wish to contribute $1000 to your portfolio, you would simply buy $1000 worth of fixed income assets. This would bring you to an allocation of 64% equities / 36% fixed income. This approach minimizes transaction costs, effort, and taxes. This portfolio rebalancing calculator can help in cases where it isn't obvious how much of a new contribution or withdrawal to allocate to each asset.

Other considerations

 * Transaction costs should be noted when deciding whether or not to rebalance. Since many transactions have costs associated with them, many investors choose to wait for their portfolio to pass a significant threshold of deviation (whether defined by percentage or dollars) before rebalancing.
 * Many investors find it difficult "selling winners" to "buy losers". To help remove emotions from the decision, many choose a specific date to rebalance (e.g. Birthday, Tax Day, etc.). Note: Investors who find the prospect daunting may want to consider Target Retirement Funds, which automatically rebalance as necessary to maintain a consistent asset allocation.
 * The frequency at which the portfolio is monitored for deviations from its target has some influence on the returns gains (or losses) that may be obtained by rebalancing.

Estimating changes in asset allocation
Normal market fluctuations do not frequently trigger rebalancing.
 * Shifting the balance of a 50/50 portfolio by 1% requires a 4% change in the price of stocks relative to bonds. All other portfolios are less sensitive, with 70/30 or 30/70 requiring a 5% change, 80/20 or 20/80 a 6% change, and 90/10 or 10/90 an 11% change. For example, a $10,000 60/40 portfolio will, after a 10% stock market drop, have $6,000 * 0.9 = $5,400 in stocks and $4,000 in bonds, for a stock allocation of $5,400 / ($5,400 + $4,000) = 57.45%, a 2.55% shift.

Spreadsheets

 * Rebalancing Bands Spreadsheet illustring how to define 5/25 absolute/relative rebalancing bands across asset classes, on Google Docs from wiki contributor Hoppy08520, 11 October 2014
 * Rebalancing spreadsheet, free download from Google Docs. Supplies three example approaches to rebalance a portfolio by allocation percentage, transfer amount, or final value; by forum member LadyGeek. To download, select File --> Download As --> Excel or OpenOffice.