Why rebalancing is crucial in rule-based investing

Friday, Feb 27 2015 by
Why rebalancing is crucial in rulebased investing

Investors have spent decades hunting down ways to profit from stock market anomalies. But in recent years the idea of systematically skimming premiums from the stocks in the market most exposed to factors like size, value, momentum, quality and low volatility has reached new levels of sophistication. So-called 'smart beta' funds now focus entirely on squeezing profits out of factors like these. Look closer at their strategies and you'll see that they put considerable emphasis on routine rebalancing. For anyone following a rule-based, factor-focused strategy, it's worth knowing why this sort of portfolio management matters.

A matter of factor

First, a bit of background. Twenty-five years ago Eugene Fama and Ken French created a ground-breaking model of stock market returns using just three factors. Their research especially pinpointed size (small caps beat large caps) and value (cheap stocks beat expensive stocks) as consistent sources of outperformance. Since then further strides to improve the understanding of stock returns have been made by luminaries like Carhart, Asness, Lakonishok and others… with proof building that the following additional factors are highly correlated with future stock returns:

  • momentum (the tendency for price trends to persist for between three months and a year)
  • quality (firms with strong finances and robust business models beat weak, deteriorating junk stocks)
  • low volatility (lower risk stocks have higher expected returns)

A number of the academics that originally researched these and other factors have since crossed into industry. They're either advising multi-million dollar funds, or running them. And one of the debates that they've been having in recent years is about the influence that rebalancing has on a factor-focused portfolio.

What rebalancing means

Rebalancing involves tweaking a portfolio so that it's weighted and diversified according to the original investment plan. Over time, even if you do nothing with a portfolio, its initial weights will eventually get out of whack as stock prices rise and fall. Traditionally, investors have been warned about this kind of drift because of the risk of being overexposed to individual positions.

In a factor-focused strategy - particularly one that uses value and momentum - there is an inherent risk of style drift without rebalancing. What that means is that value stocks that rise in price will eventually cease to offer the value premium any more. Likewise, momentum, which may last for up to a year, will eventually peter out. With the portfolio no longer exposed to those factors,…

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5 Comments on this Article show/hide all

purpleski 27th Feb '15 1 of 5

Ben thank you for this. I still consider myself in a learning phase as though I inherited a bit of money from my mother back in November 2008 I did not really start to get fairly heavily invested until late 2011 (I needed the money to get my business through the financial crisis, which I did) and then it took a couple of years to become 'fully' invested and even then I am holding 1/3 in cash. Additionally I am still learning by reading everything I can about investing (well intelligent value investing - the only type of real investing I think exists).

However the rebalancing thing does not chime with me. To me the only time to rebalance is if the reasons that you bought a particular stock have changed or you realised you made a mistake. For example if one finds a stock that is undervalued for reasons that you believe the market has not found and the stock doubles but by your reckoning the stock still remains undervalued then just because it has doubled is not a reason to sell just because it now represents say 10% of your portfolio rather than 5%.

Put it another way, say you have 10 good ideas and you invest equally in these and in order of "goodness" these individual shares grow 10% 9% 8% 7% and so on respectively each year (obviously if they all grow equally rebalancing would not be necessary) then rebalancing would cause you sell (or top slice) your best idea and retain your worst.

Or in newbieness am I missing something?

I believe Buffett works like this and I think this study would advocate non rebalancing strategy:


I would be interested in your thoughts.

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Ben Hobson 27th Feb '15 2 of 5

In reply to post #93328

Hi Michael. It's a very interesting point - and we talk about it endlessly here! I think it's undeniable that, on paper, if someone spends time and effort to pick 10 stocks and they all rise to varying degrees, that the premise of rebalancing one or more of them seems nuts. That's a stock-pickers approach - you run your winners... etc. I guess the question is about the quality of the stock-picking. It obviously needs detailed investigation, high conviction and accuracy and constant re-assessment. If that can be got right and emotions are left well out of it, then this kind of risk management maybe isn't so desirable.

With factor investing, you are playing the factor - or harvesting the premium. Buy cheap and sell high - and then trim back or rinse and repeat. And be diversified. It's definitely more systematic. And of course there are times when some factors don't work so well (value has struggled in recent years - but momentum has been strong - which is why some hedge funds love combined VM strategies).

I hope that kind of explains a bit more about the way I see it.

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pka 27th Feb '15 3 of 5

Hi Ben, That's a good article, but you didn't mention one of the main benefits of rebalancing, which is to reduce risk. If you start off with an equally weighted portfolio of, say, 20 stocks in various industries, then your portfolio is fairly well diversified. However, if you just bought and held that portfolio, after a few years one stock might have done so well relative to the others that your holding of that stock might have grown to 30% of your portfolio, and then a setback to that stock would cause a significant reduction of your portfolio's total value. Regular rebalancing back towards equal weightings therefore reduces that risk. However, rebalancing incurs transaction costs. So one approach is to set an upper bound on the percentage holding of a stock in your portfolio, e.g. 10%, and only sell some of that holding if and when your target is exceeded.

Of course, if you are regularly turning over your portfolio in a systematic way in order to capture some investment factor, then the above argument does not apply. However, even in that case, there are ways of switching from one stock to another that would incur much lower transaction charges than regularly selling the whole portfolio and reinvesting all the proceeds in a new set of stocks.

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purpleski 27th Feb '15 4 of 5


Thanks for the reply and I see what you are saying so maybe it is a question of using both concepts based on ones own level of conviction (though others might say hubris) and size of the original investment in relation to the total portfolio. An example: I am investing my 8 year old son's child allowance on an annual basis so an investment in one share once a year though I only have three stocks as I only actually started two and a bit years ago. (I am not worried about diversification as I view these three shares in the context of my overall portfolio). The time horizon is 10 to 15 years minimum.

One of the stocks I purchased was Disney 13 months ago and which is now up 47% and which under the 'rules' above would probably need rebalancing. However I have a really strong conviction that this purchases is one of the best ideas I have had todate and yes it is quite possible that the stock will pull back but I honestly believe that with the 10 to 15 year horizon mentioned that I should hold this pretty much forever and not rebalance! Why:

- content is growing in importance and Disney was ahead of the game

- their moat is enormous; there can only ever be one Micky

- they keep delivering even if they have blips

Anyway that is my penny worth.

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About Ben Hobson

Ben Hobson

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