Rebalancing Your Investment Portfolio

Come Up with a Rebalancing Plan and Stick To It to Reduce Risk

Rebalancing Your Investment Portfolio
Determining the specific re-balancing strategy you follow when managing your investment portfolio - and sticking with it - is important!. Kevin Hauff / Ikon Images / Getty Images

For individuals who opt to follow the investment strategy of maintaining certain asset allocation balances in a portfolio, the issue of rebalancing is inevitably going to arise.  (For those of you who don't know what this means, rebalancing an investment portfolio is the process of selling off and/or buying assets to bring a given pool of capital back in line with the weightings you determined best match your risk/return profile at the time you established your financial plan.

 For example, if you want 10% cash, 20% bonds, and 70% stocks, but stocks appreciate so much that they become 95% of your portfolio, you would sell off stocks to increase your cash and bond component.  The net effect of this rebalancing activity is it forces you to become a quantitative value investor.  Over time, it can serve to lower your risk - owners of fantastic businesses such as The Coca-Cola Company give up some of the wealth they would have had but if they end up with an enterprise like Enron or GT Advanced Technologies, they take resources out of harm's way, making failure less of a possibility.)

When do you rebalance?  How frequently do you rebalance?  Do you rebalance only the overall asset classes of the underlying components, too?  The answer, like most things in finance and investing, won't surprise you: It depends.  Here are some things you might want to consider when trying to answer this question for yourself, your own family, or the institution for which you manage wealth.

When Should a Portfolio Be Rebalanced?

There are generally two schools of thoughts on the appropriate frequency of investment portfolio rebalancing.  Namely, many advocates say you should rebalance either:

  1. When the asset allocation weightings get out of whack with the targets or parameters you established, or
  1. At a predetermined time or times each year.

What Should Be Rebalanced in the Portfolio (Asset Class, Components, or Both)?

Furthermore, you should rebalance either:

  1. The asset classes themselves (stocks, bonds, real estate, cash, etc.)
  2. The underlying components themselves (individual stocks such as Johnson & Johnson, Colgate-Palmolive, Hershey)
  3. Both

In the real world, there's no consistency as it is left up to each individual or asset manager to draft and apply standards.  There is a major equal-weight exchange traded fund (ETF) family that rebalances its underlying portfolio once a year in March, making sure each component is adjusted to the degree necessary to make it once again perfectly balanced but remaining 100% invested in the equity asset class.  There are some wealthy families that won't rebalance at all until the portfolio components cross a predetermined misalignment threshold, ignoring the underlying holdings as market capitalization changes exert influence but working on the asset class levels from a top-down viewpoint.  Target-date funds readjust themselves by moving more and more money from stocks to bonds as the investor ages.  Still others will even permit themselves special one-off rebalancing dates following major stock market crashes as a way to lower their overall cost basis and introduce some element of activity while still maintaining most of the benefits of passivity.

It is also popular among some investors - and this runs counter to traditional thought but it's an interesting philosophy - to refuse to rebalance at all once the initial weights are set, either in asset class or underlying component.  This is due to the amazing compounding power of a well-selected, diversified collection of common stocks over time.  On my desk at the moment, I have a data set from 1926-2010 published by Ibbotson & Associates which shows how initial asset class weightings would have skewed by the end of the period if never rebalanced.  In Table 2-6, on page 38, it illustrates:

  • A portfolio of 90% stocks / 10% bonds would have ended up at 99.6% stocks / 0.4% bonds if never rebalanced
  • A portfolio of 70% stocks / 30% bonds would have ended up at 98.5% stocks / 1.5% bonds if never rebalanced
  • A portfolio of 50% stocks / 50% bonds would have ended up at 96.7% stocks / 3.3% bonds if never rebalanced
  • A portfolio of 30% stocks / 70% bonds would have ended up at 92.5% stocks / 7.5% bonds if never rebalanced
  • A portfolio of 10% stocks / 90% bonds would have ended up at 76.3% stocks / 23.7% bonds if never rebalanced

These never-rebalanced portfolios experienced higher volatility but higher returns, as well.  Though Ibbotson doesn't mention this, they would have also enjoyed significantly improved tax efficiency as the leveraging effect of deferred taxes allowed more capital to be kept at work.

A fantastic example of this at work is the Voya Corporate Leaders Trust Fund, which is often called the "ghost ship of the investing world".  In 1935, it began by holding equal shares in 30 leading U.S. companies.  Through mergers, acquisitions, removals, and other corporate or fund-level actions, that numbers has been reduced to 22.  It runs itself with no need for a day-to-day portfolio manager.  It has crushed the S&P 500 for generations and operates at a mere 0.51% expense ratio.  Union Pacific has come to make up 14.92% of assets, Berkshire Hathaway 10.88%, ExxonMobil 9.06%, Praxair 7.62%, Chevron 5.86%, Honeywell International 5.68%, Marathon Petroleum 5.44%, Procter & Gamble 5.07%, Foot Locker 3.82%, and Consolidated Edison 3.44%, among others.  It's a sort of living, breathing, didactic exercise in the things Vanguard founder John Bogle talks about leading to superior returns: Good business, held for long periods of time, with almost no changes, at rock-bottom costs and with an eye toward tax efficiency.  Even if there are some firms in there I'm not particularly crazy about myself, quality wins in the long-run as the overall collection of stocks reflects the results of the underlying businesses.

There are no "right" answers except that you need to come up with ground rules and stick to them.  Otherwise, you can turn a good strategy - portfolio rebalancing - into another excuse to drive up costs and lower returns.