Rebalancing by Selling

When new contributions and dividend reinvestment cannot restore your allocation—because you are retired, your portfolio is static, or drift is large—you must rebalance by selling overweight positions and buying underweight ones. This is the most direct form of rebalancing, but it incurs transaction costs and, in taxable accounts, capital gains tax.

Key takeaways

• Selling is necessary when contributions and dividends cannot close the drift gap.
• You sell from the most overweight asset class and buy the most underweight one.
• In taxable accounts, tax-loss harvesting and the timing of sales (to realise losses or defer gains) matter greatly.
• In tax-advantaged accounts, selling is cost-free and can be done frequently without penalty.
• The decision to sell is tactical: you decide not only whether to rebalance but which positions to rebalance and in what order.

When selling is necessary

You must sell when:

1. You are in drawdown. You are retired and living off your portfolio. New contributions are zero. Rebalancing via contributions is not an option.

2. Your portfolio is static. You have stopped accumulating, but you are not yet drawing down. Your portfolio is neither growing nor shrinking significantly. Drift will persist unless you sell.

3. Drift is large. Your allocation has drifted significantly—perhaps 10% or 20% from target—and contributions or dividends cannot restore it within a reasonable time.

4. Contributions are tiny. Your contribution rate is so small relative to your portfolio that directing contributions would take years to correct drift. It is more efficient to sell.

5. You are rebalancing in a tax-advantaged account. There is no tax cost to selling, so you might as well maintain tight allocations.

The mechanics of selling to rebalance

Step 1: Identify the overweight asset. Which asset class is furthest above its target weight? This is the one to sell.

Step 2: Identify the underweight asset. Which asset class is furthest below its target weight? This is the one to buy.

Step 3: Calculate the trade size. How much must you sell from the overweight and buy in the underweight to return both to target?

Example: You have a €100,000 portfolio with a target of 60% stocks (€60,000) and 40% bonds (€40,000). Your current allocation is 70% stocks (€70,000) and 30% bonds (€30,000). To rebalance:

• Sell €10,000 of stocks (bringing stocks to €60,000).
• Buy €10,000 of bonds (bringing bonds to €40,000).

After the trade, you are back at 60/40.

Choosing what to sell

In a taxable account, you have a choice about which specific positions to sell—and this choice matters enormously for tax efficiency.

Tax-loss harvesting

If you own a position with an unrealised loss, selling it realises the loss for tax purposes. That loss can offset other capital gains in your portfolio, reducing your tax bill. This is called tax-loss harvesting.

Example: You hold €10,000 of VWRL (Vanguard World UCITS ETF) with an unrealised loss of €2,000 (you paid €12,000). You also hold €5,000 of VTI (Vanguard US Total Stock ETF) with an unrealised gain of €3,000 (you paid €2,000).

If you must sell €10,000 to rebalance, you can choose to sell the VWRL position. This realises the €2,000 loss. The loss can offset the €3,000 gain in VTI, reducing your net capital gain from €3,000 to €1,000. The tax benefit is material (€2,000 × your marginal tax rate).

Selling highest-gain positions

If you do not have losses to harvest, you can minimise your capital gains tax by selling positions with the smallest gains (or losses). Selling a position with a €1,000 gain is less costly than selling one with a €10,000 gain.

However, this assumes you are rebalancing by selling the overweight asset. If the overweight asset is one you want to stay overweight in (because you have high conviction or it is a tax-advantaged account), selling the highest-gain position defeats the purpose. You want to sell the overweight asset, regardless of its gain.

Lot selection

If you have purchased a position multiple times at different prices, you may be able to choose which lot (which batch of shares at which cost basis) to sell. If your brokerage supports specific lot selection, you can sell the lot with the lowest gain. This reduces your capital gains tax.

For example, if you bought VXUS (Vanguard US Equity ETF) at three different times (€1,000 at €50/share, €2,000 at €100/share, €1,000 at €120/share), and you now need to sell €2,000 worth, you can specifically sell the lot bought at €50/share (which has the largest gain). Conversely, you can sell the lot bought at €120/share (which might have a loss or smallest gain).

When to sell: timing considerations

In tax-advantaged accounts

Timing does not matter. There is no tax cost. Sell whenever you want to rebalance. If you are rebalancing quarterly, sell quarterly. If annually, sell annually. The cost is only the transaction cost (bid-ask spread), which is trivial for most ETFs.

In taxable accounts

Timing can matter if you expect changes in your tax situation:

• Before a loss year. If you expect low income (sabbatical, job loss, early retirement), rebalancing in that low-income year realises capital gains at a lower tax rate.
• Before large charitable donations. If you are donating appreciated securities to charity (which is tax-efficient), you do not need to rebalance those positions in advance.
• Before year-end. Harvesting losses before December 31 uses those losses in the current tax year. Losses harvested after December 31 apply to the next year.

For most investors, these timing optimisations are minor. The bigger factor is simply whether you can realise losses (tax-loss harvesting) or whether you will realise large gains.

Rebalancing vs. tax-loss harvesting

There is a subtle interaction between rebalancing and tax-loss harvesting. If you have an underperforming position with a large loss, you might want to sell it (to harvest the loss) without immediately rebalancing to your target. You could sell the losing position and buy a similar (but not substantially identical) position in a different asset class.

For example, if VXUS has fallen 20% and you have a large loss, you might sell VXUS and buy a similar (but different) international equity ETF. This harvests the loss without a time delay, and it keeps your international equity exposure. Then, months or quarters later, you can rebalance from that new position.

This strategy requires careful analysis of the relevant rules (wash-sale rules in the US, for example) and is most suitable for sophisticated investors.

Order of operations

When you must rebalance by selling, here is a practical order:

1. In tax-advantaged accounts: Rebalance freely. Sell the most overweight and buy the most underweight.

2. In taxable accounts with losses: Harvest losses first. Sell positions with unrealised losses to realise them for tax purposes. Then, rebalance the rest via contributions or additional sales if needed.

3. In taxable accounts with only gains: Sell the positions with the smallest gains or defer rebalancing until you have losses to harvest.

Rebalancing execution flow

Next

We have covered how to rebalance by selling, including tax-loss harvesting tactics. But the broader picture is the tax impact of rebalancing itself. In the next article, we examine what happens to your after-tax returns when you rebalance in taxable accounts, and why taxable accounts deserve special rebalancing rules.

Related concepts

• Rebalancing With New Contributions
• Tax Implications of Rebalancing