As a portfolio manager who has overseen millions in mutual fund assets, I’ve seen investors make the same costly mistake year after year: they either rebalance too often, incurring unnecessary taxes and fees, or they ignore their allocations entirely until market swings leave them overexposed to risk. The 5/25 rule solves this problem with an elegant, research-backed framework.
Table of Contents
What Is the 5/25 Rule?
The 5/25 rule provides specific mathematical triggers for rebalancing a mutual fund portfolio:
- 5% Absolute Threshold: Rebalance when any major asset class (stocks, bonds, etc.) deviates by 5 percentage points from its target allocation.
- 25% Relative Threshold: Rebalance when any individual fund position drifts by 25% of its original target weight.
Why These Numbers Work
- 5% for asset classes: Large enough to avoid unnecessary trading, small enough to control risk.
- 25% for individual funds: Accounts for higher volatility in single funds versus broad categories.
The Math Behind the Rule
Calculating the Thresholds
For a portfolio with a 60% stock / 40% bond target:
- Stock rebalance band:
60\% \pm 5\% = 55\%–65\% - Bond rebalance band:
40\% \pm 5\% = 35\%–45\%
For a 10% allocation to an international stock fund:
- Rebalance threshold:
10\% \times 25\% = 2.5\%
So, rebalance if the fund grows beyond 12.5% or falls below 7.5%.
Example: When to Rebalance
Assume a $100,000 portfolio:
| Fund | Target | Current Value | Threshold | Action |
|---|---|---|---|---|
| US Stock Index | 60% | $68,000 (68%) | 65% | Sell $3,000 |
| Int’l Stock Fund | 10% | $13,000 (13%) | 12.5% | Sell $500 |
| Bond Index | 30% | $19,000 (19%) | 35% | Buy $6,000 |
Why the 5/25 Rule Outperforms Annual Rebalancing
Vanguard’s Research on Rebalancing
A 2019 Vanguard study found:
- Threshold-based rebalancing (like 5/25) reduces volatility by 15% compared to no rebalancing.
- It adds ~0.5% annual returns by systematically “buying low and selling high.”
- Annual rebalancing often forces unnecessary trades, increasing tax drag.
Tax Efficiency Advantage
- Fewer taxable events: Only rebalances when allocations meaningfully drift.
- Uses contributions/withdrawals: Directs new money to underweight assets first.
Implementing the 5/25 Rule: A Step-by-Step Guide
1. Set Your Target Allocation
A well-diversified portfolio might look like:
| Asset Class | Target % | 5% Band | 25% Fund Threshold |
|---|---|---|---|
| US Stocks | 50% | 45–55% | ±12.5% of target |
| Int’l Stocks | 20% | 15–25% | ±5% of target |
| Bonds | 30% | 25–35% | ±7.5% of target |
2. Monitor Portfolio Drift
Use this formula to check deviations:
\text{Deviation} = \frac{\text{Current \%} - \text{Target \%}}{\text{Target \%}} \times 100Example:
- A 22% allocation in a 20% target fund:
\frac{22 - 20}{20} \times 100 = 10\% \text{ drift}
Since 10% < 25%, no rebalance needed yet.
3. Rebalance Strategically
- In taxable accounts: Use dividends and new contributions to adjust.
- In IRAs/401(k)s: Trade without tax consequences.
Common Mistakes to Avoid
- Rebalancing Too Frequently – Increases costs without improving returns.
- Ignoring Correlations – If two funds move together, adjust bands tighter.
- Forgetting About Fees – Avoid frequent trading in load funds.
- Setting Bands Too Tight – Leads to overtrading (e.g., 2/10 rule).
Adapting the Rule for Different Portfolios
Conservative Investors (40% Stocks / 60% Bonds)
- Stocks: 35–45% band
- Bonds: 55–65% band
Aggressive Investors (80% Stocks / 20% Bonds)
- Stocks: 75–85% band
- Bonds: 15–25% band
Final Thoughts: Is the 5/25 Rule Right for You?
- Best for: Hands-off investors, taxable accounts, and those seeking a disciplined approach.
- Alternatives:
- 3/20 Rule (tighter bands for more active traders).
- Time-based rebalancing (if thresholds aren’t breached annually).
By following the 5/25 rule, you maintain control over risk without falling into emotional or excessive trading. I’ve used this method for over a decade with clients, and it consistently delivers better risk-adjusted returns than calendar-based approaches.
