How portfolio rebalancing can help avoid the risk of style-drift

Wednesday, Dec 06 2017 by
How portfolio rebalancing can help avoid the risk of styledrift

With just a few weeks to go until the end of the year, it’s inevitable that thoughts start turning to portfolio housekeeping and making new investment resolutions for 2018.

Overall, it’s been a strong year for equities. Strategies that target small-cap growth companies have done particularly well, and we’ve seen noticeable strong returns in higher quality value strategies, too.

But the consequence of these kinds of trends is that they can leave some portfolios drifting well away from their intended investment target. If you were an investor in small GARP (growth at a reasonable price) shares in early 2017, you might now be holding a group of larger and more expensive looking stocks. While that’s clearly a good thing, your exposure to that successful small-cap GARP strategy would have drifted away. To continue with that investment style you’d need to tackle the thorny issue of rebalancing.

Why rebalancing causes confusion

Even if you do nothing with a portfolio, its initial weights will slide out of balance over time as valuations change. The idea with rebalancing is that it cuts the risk of being overexposed to a small number of large positions, where an unexpected disaster could be seriously damaging.

Yet rebalancing is one of those subjects that rankles with some investors. That’s because, conventionally, it means trimming back successful holdings and feeding funds into lagging stocks. This kind of trading is counter-intuitive to many investors because it racks up trading fees, spread costs and potentially even taxes. Plus it doesn’t sit well with the idea of running winners and selling losers. All these reasons are enough to send rebalancing to the bottom of the list of priorities.

Indeed, rebalancing not only has disadvantages, but it’s arguably unnecessary for some types of investors. In Stockopedia’s Four Investor Suits, active traders and stock market ‘hunters’ (like our own Paul Scott) build and weight portfolios based on detailed analysis and conviction. In some ways, this kind of constant adjustment dispenses with the need for periodic rebalancing.

Staying focused on investment styles

But for more passive ‘owners’ and ‘farmers’, rebalancing can be a very important part of some strategies - especially those that aim to harvest powerful market premiums like value and momentum. For stock market ‘farmers’ who run portfolios based on these kinds of investment styles, there is a constant risk of style drift without rebalancing.

What this means…

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As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested. ?>

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6 Comments on this Article show/hide all

cwoodrow555invest 6th Dec '17 1 of 6

Every investment pundit and his dog is always banging on about 'rebalancing'. I am a buy and hold investor and have never 'rebalanced' in my life and have no intention of doing so!

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underscored 6th Dec '17 2 of 6

In reply to post #250318

Thanks for the directly relevant commentary supported by empirical evidence, and comparison of returns.

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Ian Booker 7th Dec '17 3 of 6

I think the article is appropriate for all.
It made me appreciate that considering myself a 'pruner' on a more or less monthly basis can see a dangerous drift into inaction through smugness over my winners and love of my carefully selected losers which will surely come good in the fullness of time!
Regrettably ruthlessness does not come easy even over stock selection which has been much reduced to strait number comparison.

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Graham Codd 12th Dec '17 4 of 6

I do find that it is better to have my shares spread over all sectors and it it is easy to lose sight of this if buying and selling on a monthly basis. Some sectors do better in falling markets, when investors rush to stability and I believe a fairly wide range is necessary.

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Lemmy Caution 4th Jan 5 of 6

I buy stocks that fit my portfolio when they are cheap and sell when they are dear. Mostly this rebalancing is profit taking and reinvesting. As a guide my transaction costs must never exceed a low percentage of any gross profit. I raise stop loss prices as shares' profits increase. A core of high quality shares, bought cheaply, which yield good dividends, is not sold but topped up when low prices are available.

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underscored 6th Jan 6 of 6

Dear stocko team, it would be great if you could update the style analysis to risk rating and stock rank style please

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