The thorny issue of rebalancing a stock portfolio is something we’ve been looking at closely in recent weeks. It’s a subject that matters more to some investors than others. Stock market hunters often recoil in horror at the idea of selling winning positions and buying laggards. But for the rules-based “farmers” who build portfolios to harvest value and momentum premiums over the long term, rebalancing is much more important.
Why is it important? Well, rebalancing is part of the precarious art of managing risk. Keeping your positions in line with their original target allocations profits from a phenomenon known as mean reversion. In simple terms, this means that shares that have roared ahead may fall back down, while those that have so far underperformed (assuming they still meet your strategy rules) could well eventually rise. Ultimately, it’s about the Robin Hood approach of systematically taking from the rich and giving to the poor and remembering that, regardless of your strategy, it may take considerable time to fully ‘out’ the value of some shares. In The Little Book That Beats the Market, Joel Greenblatt puts it like this:
“Even superior investment strategies may take a long time to show their stuff. If an investment strategy truly makes sense, the longer the time horizon you maintain, the better your chances for ultimate success. Time horizons of 5, 10, or even 20 years are ideal.”
Investors are routinely drilled on the importance of rebalancing but the single most important factor in deciding on how and when to do it is costs. Depending on individual circumstances, trading shares can rack up crippling broker fees, crystallise capital gains taxes and the wide spreads on some shares can also eat into profits. We previously looked at the costs of rebalancing and how their compounding effects can destroy your long term investment returns. So it’s essential to figure out how these costs will impact your returns long before you start thinking about rebalancing your positions. But once you have, there are a few ways to tackle it…
Calendar rebalancing
Some of the most common advice is to rebalance according to a fixed timetable, such as every six or 12 months. In theory this helps to maintain the discipline of routinely looking at how the shape of a portfolio has changed. On the rebalancing date, in a rules-based strategy, new candidates that qualify for the rules will…
