Earlier in this series of articles on Portfolio Management we looked at why equally weighting all the positions in a portfolio is a sensible approach for many investors. The trouble of course is that over time, even if you do nothing with that portfolio, those weights will get out of whack. As some shares soar and others stumble, position sizes change and that can leave you over-exposed to a smaller number of stocks. Rebalancing the portfolio can fix this issue but it’s important to remember that too much tinkering can incur costs that could damage returns.
What is rebalancing?
Rebalancing means tweaking your portfolio so that it’s weighted and diversified according to the original plan. That can mean taking the counter intuitive decision to trim positions in stocks that are doing well. In doing so, you deploy cash to stocks that are doing less well (or cut loose the laggards and introduce new stocks to the portfolio). The philosophy behind rebalancing is mean reversion. What that means is that markets and stocks tend to move in cycles, and a poorly performing asset won't always do badly and a high-flyer may eventually come back down to earth.
Both buy-and-hold investors and stock picking ‘hunters’ are sometimes wary of rebalancing because it contradicts advice that you should cut your losers and run your winners. The short answer is that unless you’re an above average stock-picker who can control the emotions of fear and greed and expertly time the sale of investments, some form of rebalancing may well help to manage risk.
Morningstar founder Pat Dorsey illustrates the perils of not rebalancing in The Little Book That Builds Wealth. In it, he tells the story of a stock he bought in the mid-1990s called EMC Corporation. He watched the price go from $5 to $100 in three years - and right back to $5 a year later, along with the majority of his return. He said: “I had made a great purchase decision but my overall return on the investment would have been far, far greater had I been smarter about selling.”
Many market professionals and guru investors endorse the idea of rebalancing. A common suggestion - from the likes of fund manager Joel Greenblatt and financial theorist Robert Haugen - is to ‘churn’ a portfolio no more than annually. Others suggest half-yearly, quarterly or even monthly. Deciding on the best rebalancing strategy is…
