Think Like a Portfolio Strategist: How to Rebalance Your Portfolio in a Shifting Market

Rebalancing your portfolio is a critical – yet often misunderstood – aspect of long-term investing. In our recent Morningstar Investor subscriber webinar featuring portfolio strategist Amy Arnott and Head of Individual Investor Adley Bowden, we explored why rebalancing is essential, when and how to approach it, and discussed practical strategies to keep your portfolio aligned with your goals.

Here are the main takeaways:

1. Why Rebalancing Matters

Rebalancing ensures your portfolio stays aligned with your target asset allocation, helping you manage risk effectively. Over time, market fluctuations can cause your portfolio to drift – potentially exposing you to unintended levels of risk.

For example, a 60/40 stock-to-bond allocation, left unchecked for a decade, would likely shift to 80% stocks. Rebalancing acts as a guardrail, maintaining your intended risk level and creating a built-in discipline that counteracts the emotional tendencies many investors struggle with.

*Related reading: Our Best Investment Portfolio Examples for Savers and Retirees

2. When to Rebalance

There are two primary approaches, and what you select depends on your personal preference. The key is to choose a method that works for you and apply it consistently.

• Calendar-Based Rebalancing: Rebalance on a set schedule (e.g., quarterly, semi-annually, or annually). This method is predictable and easy to implement.

• Threshold-Based Rebalancing: Rebalance only when an asset class drifts beyond a set percentage, e.g., 5% above or below your target. This approach is more precise and minimizes unnecessary trading.

3. How to Identify Imbalances

Start by comparing your current asset mix to your target allocation, as Adley Bowden highlights in his portion of the webinar (for step-by-step guidance, skip to 13:36 in the video above). Review your overall balance of stocks, bonds, and cash, and then turn to the portfolio’s mix between US and international stocks. Keeping roughly a third of your equity exposure outside of the US is a reasonable target if you want to be in line with the global market portfolio.

A few other areas might also be out of balance: because growth stocks have gained nearly twice as much as value stocks over the past three years, and the tech sector has been strong, you may find that your portfolio is underweight in value stocks and/or small-cap stocks. Specialized assets, such as gold or bitcoin, should also be reviewed to ensure they align with your original plan.

4. Rebalancing for Retirement

For younger investors, rebalancing is about maintaining long-term growth. However, for those nearing retirement, it’s crucial for creating stability and managing sequence of returns risk*. Strategies include increasing allocations to high-quality bonds and maintaining cash reserves to avoid selling stocks during market downturns.

*Related reading: What’s a Safe Retirement Withdrawal Rate for 2026?

5. Tax-Efficient Rebalancing

In taxable accounts, rebalancing can trigger capital gains taxes. To minimize this, prioritize adjustments in tax-deferred accounts like IRAs or 401(k)s. If rebalancing in taxable accounts, consider offsetting gains by selling holdings with losses.

6. Practical Tips

If applicable to your life stage, consider using required minimum distributions (RMDs) in tandem with annual rebalancing.

Finally, another option for rebalancing is to funnel new contributions into underweight asset classes to gradually realign your portfolio.

7. Closing Thoughts

In the current market environment, many investor portfolios are heavily tilted toward large-cap U.S. growth stocks simply because they’ve done so well over the past 10 years. Taking the time to rebalance your portfolio can help you keep risk under control and make sure your asset mix hasn’t drifted too far away from what you originally planned.

Demonstration

For a hands-on demonstration of rebalancing strategies using Morningstar Investor’s portfolio tool, skip to 13:36 in the above video, where Adley Bowden walks through practical applications you can put into action right away.

Q&A

During the webinar, we received 100+ questions – here are a few that Amy answered live.

What should rebalancing look like prior to retirement?

There are a couple of different ways to approach this. If you’re taking a bucket approach to withdrawals, some basic guidelines that we often recommend would be keeping about one or two years’ worth of planned spending in cash, which might work out to about 10% of the portfolio, and then looking at the next, say, 3-10 years’ worth of spending you’ll want to keep it in intermediate-term, high-quality bonds, which could be about 40% of the portfolio, and then for spending 10 years and beyond, you could have equity exposure which might be about 50% of the portfolio.

We’ve also looked at this from the perspective of safe withdrawal rates, and we recently published our annual study on the state of retirement income, and we found that if you’re looking for a high probability of success, the highest safe withdrawal rates were with portfolios with a decent amount of fixed income exposure, so at least 50-60% bonds. And another benchmark you could look at would be the average target date fund allocation, which has about 42% stocks at retirement. Depending on which angle you look at, you’ll kind of end up in the same place, which is having a decent amount of fixed income exposure. This can help ensure you’re not taking on too much risk and that you’re not running into speed bumps from sequence-of-returns risk at the beginning of retirement.

What is the likelihood that we’re in an AI bubble, and how should I account for this possibility while rebalancing across assets?

This is really the trillion-dollar question right now; there’s a huge amount of enthusiasm for AI and large language models, and the potential that they could really transform the entire economy. And whenever you have a potentially transformative technology like this, you tend to get a lot of growth and wealth creation, but you can also get a lot of speculation and potential bubbles. So, a couple of examples you could look back on would be the railroad era, going back to the 1800s, where there was a huge amount of growth but also speculative investment, as well as tech stocks in the 1990s.

If you look at the Magnificent Seven*, our equity analysts don’t currently think that they’re especially overvalued as a group, although they do think that a couple of them, specifically AAPL and TSLA are currently trading above their FVE, but the other stocks, like Alphabet, Amazon, Microsoft, Nvidia, are, in the analysts’ opinion, fairly valued.

Another point our equity analysts have made is that so far the demand for AI has been exceeding the supply, and the fundamentals on those big players have generally been strong, but if you go beyond the “Mag 7,”  there are more signs of speculation, and valuations that may be excessive; the sheer amount of money flowing around, with venture capital and debt financing to build these huge data centers and capital expenditures required for AI, are potential warning signs. I don’t think anyone knows exactly what the probability is that we’re in a bubble, but if you’re concerned about potential risk there, there are a few different steps that you could take to make sure you’re not overly exposed to artificial intelligence:

• If you have a broad market index fund like an S&P 500 index fund, you’re already getting a lot of exposure to that area, and if in addition to that index fund, you also own a fund like QQQ for example, or a technology sector fund, you’re really doubling up on the exposure and the potential risks, so that’s something that you may want to avoid.
• If you already own individual stocks in AI, that’s also something you can look at to pull back on to make sure you’re not overexposed.
• Another thing you could do if you’re concerned about risk there, make sure you have some exposure to value stocks and small-cap stocks as well as areas like, say, dividend growth stocks, which would be less exposed to AI, and then making sure you have enough fixed income exposure is also key, so if we do hit some kind of speed bump in the market, that you’re not overly exposed to the downside there.

*Related reading: Beyond the Magnificent Seven: Unlocking Value in a Concentrated Stock Market and Worried About an AI Crash? Here’s How to Diversify Your Portfolio

How to allocate across taxable brokerage, 401K, IRA, and Roth IRA accounts?

I think it’s always helpful to diversify your tax exposure; we’ve written a few articles* about a hierarchy for your investments. You’d want to start by making sure you have an emergency fund, which would typically be in a taxable brokerage account. After that, the next step would be investing in your 401(k), at least to the level where you’re getting a company match. After that, you could look at additional funding in a taxable brokerage account if you have shorter-term goals, or, especially if you’re a younger investor, a Roth IRA could be a good option if you’re in a low tax bracket currently and might be in a higher tax bracket in retirement.

That said, we’ve recently interviewed, Cody Garrett and Sean Mullaney for our podcast, The Long View,**  who have written about tax planning to and through retirement, and they brought up the point that for the vast majority of investors, you’re most likely going to be in a lower tax bracket after retirement, as opposed to earlier than retirement, so you’d probably want to choose a traditional IRA or 401K as opposed to a Roth IRA.

*Related reading: A Hierarchy for Retirement Savings and Asset Location: A Tax-Aware Investment Strategy

**Subscribe to The Long View for a forthcoming episode featuring Cody Garrett and Sean Mullaney

How do you determine the optimal Roth conversions in early retirement years before taking Social Security?

If you are early in retirement, say you retired at 65, you’re not going to start being subject to Required Minimum Distributions (RMDs)* until age 73. So you have a pretty long runway to start making Roth conversions. What you would typically want to do, either in Excel or in various online tools, is experiment with different conversion amounts and try to see how much you can convert to a Roth without tipping yourself into a higher tax bracket. But those years leading up to when RMDs kick in can really be a great time to do some Roth conversions so that you’re not getting hit by excessive taxes when you do start making those RMD withdrawals. 

*Related reading: What Retirees Need to Know about Required Minimum Distributions