Why Rebalancing Feels Wrong, and Why You Should Do It Anyway

Every few months, a notification arrives. Your smallcase is due for a rebalance. Some investors act on it immediately. Others wait. A few skip it entirely.

The hesitation is understandable. Rebalancing asks you to make active decisions about your portfolio at exactly the moments when markets feel most uncertain. And because those decisions often involve selling something that has risen and buying something that has fallen, or exiting a stock mid-loss, they run headlong into some deeply ingrained investor instincts.

This article explains what rebalancing is actually doing, why it tends to feel wrong, and what the evidence says about when it matters most.

What Rebalancing Actually Does

Rebalancing is a portfolio maintenance process. It does one thing: it ensures that your smallcase continues to represent the strategy you invested in.

A Windmill Capital smallcase is built on a specific framework. The Value and Momentum Model smallcase selects lowly valued stocks with recent price momentum. The Quality Smallcap selects high-quality small-cap companies exhibiting positive momentum trends. Every quarter, markets move. Companies report earnings. Sectors rotate. The set of stocks that best represented the strategy three months ago is not necessarily the same set that best represents it today.

Rebalancing corrects that drift. It exits stocks that no longer satisfy the selection criteria and enters the ones that now do. It also corrects weights when individual positions have drifted above or below their intended allocation.

That is the whole job. Not to time the market. Not to improve returns on demand. To keep the strategy intact.

What Rebalancing Doesn’t Do

Rebalancing does not protect a portfolio from market falls. If markets decline, your smallcase declines with them, whether it was rebalanced last week or six months ago. Both go down together.

What changes is what happens on the way back up. A rebalanced smallcase holds the stocks that currently best fit the strategy, so it is better positioned when conditions improve. An unrebalanced one holds whatever was in the portfolio at the last update, which may or may not still qualify.

Rebalancing also does not produce results instantly. New stocks enter the portfolio the moment you apply the update, but whether those stocks contribute to performance depends on market conditions, timing, and whether the factors driving their selection continue to hold. The benefit of rebalancing shows up across multiple cycles, not in the days immediately following the update.

Why It Feels Wrong

There is a well-documented pattern in investor behaviour called the disposition effect. Investors tend to sell winners too quickly, because locking in a profit feels satisfying, and hold losers too long, because selling makes the loss feel real and final.

Rebalancing cuts against both instincts simultaneously.

When a stock has risen 40% and the model says hold because it still meets the criteria, the instinct is to sell and capture the gain. When a stock has fallen 30% and the model says exit because it no longer qualifies, the instinct is to hold on and wait for a recovery. The systematic process pushes in one direction; the emotional response pushes in the other.

The hardest version of this plays out when a portfolio is in a loss. An investor sitting on a 10% drawdown receives a rebalance notification and faces a question that feels loaded: if I act now, am I locking in the loss?

The answer is no, but understanding why requires separating two things that feel connected. The drawdown exists regardless of whether the rebalance is applied. Choosing not to rebalance does not make the loss go away; it just leaves the portfolio holding stocks that may no longer meet the strategy’s criteria when the recovery comes. Rebalancing in a loss asks you to trust the process at the exact moment it feels hardest. That discomfort is real. But the loss itself is not created by the decision to act.

Questions Investors Ask

Is rebalancing just a form of market timing?

No. Market timing means forming a view on where prices are going and acting on it. Rebalancing does neither. A momentum strategy does not exit a stock because it expects the price to fall. It exits because the stock’s recent momentum rank has dropped below the strategy’s threshold. The trigger is the strategy signal, not a price prediction.

Does rebalancing guarantee better returns?

No, and it is worth being direct about this. Rebalancing is a maintenance process. In favourable conditions, a well-rebalanced portfolio performs better because it stays aligned with the strategy’s current selections. But if markets are in a broad sell-off or facing a macro shock, rebalancing cannot neutralise that pressure. What it does is ensure the portfolio is correctly positioned when conditions improve.

Should I wait for markets to fall before rebalancing?

A falling market is not the trigger. A stock failing the strategy’s criteria is. These are different things. A high-quality company does not become a bad company because its stock price has temporarily declined. The model does not react to price alone; it asks whether the reasons for holding the stock have been fundamentally invalidated. When they have, due to a regulatory development, a business model shift, or a sustained deterioration in the relevant metrics, that is when action is taken, regardless of whether markets are up or down.

Is more frequent rebalancing better?

It depends entirely on the strategy. A momentum strategy with a three-month lookback requires quarterly rebalancing because momentum signals update on that cycle. A quality-focused strategy that screens for long-term earnings consistency does not benefit from monthly rebalancing. It generates unnecessary transaction costs and potential tax events without improving the portfolio’s alignment. The rebalance frequency is calibrated to how quickly the underlying strategy’s inputs actually change.

What about selling winners too early?

The model does not predict where a stock’s price is going. It ranks stocks by what they have already done. A stock added to the portfolio because it ranked in the top quartile of three-month returns may, by the next review, have been overtaken by other stocks that moved more strongly. The model removes it not because it expects the price to fall, but because other stocks now rank higher on the same criteria. That process can feel like leaving gains on the table. Over multiple cycles, it is what keeps the portfolio at the leading edge of the strategy rather than anchored to last quarter’s selection.

If my portfolio fell after a rebalance, does that mean the rebalance was wrong?

This is the most emotionally intuitive conclusion, and the least analytically sound. Markets do not care when you last rebalanced. If a portfolio is updated in December and markets fall 15% in January, the portfolio falls too. That says nothing about whether the rebalance was correct. A rebalance can only be evaluated against what it was supposed to do: keep the strategy aligned with its criteria. What prices do in the weeks that follow is a separate question entirely.

Is rebalancing unnecessary when markets are rising?

Bull markets are actually when drift gets most severe. When everything is rising, the stocks that have risen most take up an ever-larger share of the portfolio simply through price appreciation. A position that was 8% of the portfolio at the start of the year might be 14% by year-end, not because anyone decided to increase it, but because it outperformed. Rebalancing corrects that by trimming positions that have grown beyond their intended weight and adding to positions that still qualify but have not moved as much yet.

The One Thing to Hold Onto

Rebalancing is not a button you press to improve returns on demand. It is what keeps a smallcase strategy systematic, ensuring that what you own is what the strategy currently selects, not what you bought six months ago and have not had the time or conviction to revisit.

Apply rebalances consistently, and five years from now your portfolio will still reflect the strategy you chose. Skip them, and it becomes a record of every hesitation, every moment the process felt wrong and you overrode it.

Rebalancing does not guarantee returns. It guarantees that the strategy gets a fair chance to deliver them.

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