Rebalancing a Two-Fund Portfolio

Rebalancing a two-fund portfolio means restoring your target split between stocks and bonds (or any two assets) after price movements have shifted the weights. The arithmetic is straightforward: calculate what each position should be worth at your target allocation, then either sell the overweight asset and buy the underweight one, or route new contributions to the underweight side.

When and why a two-fund portfolio drifts

You start with a simple plan: 60% stock funds, 40% bond funds. A 60/40 portfolio has a moderate risk profile—growth-oriented but not reckless.

After one year of returns, stocks have rallied 15% but bonds have gained only 3%. Your $100,000 portfolio is now:

• Stocks: $100,000 × 0.60 × 1.15 = $69,000
• Bonds: $100,000 × 0.40 × 1.03 = $41,200
• Total: $110,200

Your new allocation is $69,000 / $110,200 = 62.6% stocks and $41,200 / $110,200 = 37.4% bonds. You have drifted to nearly 63/37.

This drift matters because it changes your portfolio’s risk and return profile. You intended moderate risk; you now have above-average equity exposure. In a market downturn, you will suffer more volatility than you planned for. Conversely, you capture less bond stability.

Rebalancing restores your intended allocation, preventing unintended risk creep.

Method 1: Sell-and-buy rebalancing

The direct method is to sell the overweight asset and buy the underweight one.

Using the example above, with a target 60/40 and a current portfolio of $110,200:

You sell $2,880 of stocks and use the proceeds to buy $2,880 of bonds. After the trade, you own:

• Stocks: $69,000 – $2,880 = $66,120
• Bonds: $41,200 + $2,880 = $44,080
• Total: $110,200
• Allocation: 60% / 40% (restored)

Costs and taxes

Selling triggers costs:

• Bid-ask spread: When you sell stock funds, you receive the bid price (slightly lower than the market price). When you buy bonds, you pay the ask price (slightly higher). A typical spread is 0.01%–0.1%, a minor but real cost.
• Trading fees: Most brokerages charge little or nothing on mutual funds and ETFs now, but confirm your cost.
• Capital gains tax: If this is a taxable account and your stock fund has appreciated, selling may crystallize a capital gains tax liability. Bonds sold at a loss could trigger tax-loss harvesting opportunities.

In a tax-deferred account (401k, IRA), there is no capital gains tax, so sell-and-buy is costless except for the tiny bid-ask spread.

Method 2: Contribution-only rebalancing

If you are still adding money to the portfolio—perhaps via monthly savings or an annual contribution—you can rebalance without selling anything.

Suppose your $110,200 portfolio (62.6% stocks, 37.4% bonds) receives a $3,000 annual contribution. Instead of splitting it 60/40, you send 100% of the $3,000 to bonds (the underweight).

After the contribution:

• Stocks: $69,000 (unchanged)
• Bonds: $41,200 + $3,000 = $44,200
• Total: $113,200
• Allocation: $69,000 / $113,200 = 60.9% stocks; $44,200 / $113,200 = 39.1% bonds

Not perfectly 60/40, but much closer to your target. If you continue directing contributions toward bonds for another year or two, the portfolio gradually drifts back.

When contribution-only works best

Contribution-only rebalancing is ideal when:

• You are in a taxable account and selling would trigger large capital gains taxes.
• You have regular cash inflows (salary contributions, dividends reinvested) and can redirect them strategically.
• The drift is modest—the allocation is close enough that a few years of biased contributions will restore it without urgency.

It is poor when:

• You have no planned contributions or receive them infrequently.
• The drift is large and you need to restore the allocation quickly (a market crash may make this urgent).
• You are in a tax-deferred account where selling has no tax cost.

Choosing a rebalancing schedule

How often should you rebalance? Common approaches:

A simple rule: rebalance once per year, or whenever an asset class has drifted more than 5 percentage points from its target (e.g., stocks were 60%, now 65% or 55%).

In taxable accounts, annual rebalancing in December can be combined with tax-loss harvesting—selling losers to offset gains elsewhere, then repurchasing them.

A complete worked example

You have a $200,000 portfolio: $120,000 in a stock index fund (60%) and $80,000 in a bond fund (40%).

One year passes. The stock fund gains 12%; the bond fund gains 4%.

Current values:

• Stocks: $120,000 × 1.12 = $134,400
• Bonds: $80,000 × 1.04 = $83,200
• Total: $217,600
• Current allocation: $134,400 / $217,600 = 61.8% stocks; $83,200 / $217,600 = 38.2% bonds

Target allocation (60/40):

• Target stocks: $217,600 × 0.60 = $130,560
• Target bonds: $217,600 × 0.40 = $87,040

Rebalance trades:

• Sell stocks: $134,400 – $130,560 = $3,840
• Buy bonds: $87,040 – $83,200 = $3,840

After the trade, you own $130,560 in stocks (60%) and $87,040 in bonds (40%)—back to your target.

The small cost (bid-ask and any fees) is negligible against the benefit of maintaining disciplined risk exposure.

See also