Portfolio power: Rebalancing

In this series of articles on portfolio power, we explore key topics in portfolio management — decisions that affect the portfolio as a whole, rather than decisions that affect individual investments. We cover some of the “everyday” decisions of portfolio management, including topics such as rebalancing, foreign exchange and cash management. These topics tend to get a lot of attention from professional investors but less attention from self-directed investors. By exploring these topics in portfolio management, we hope that self-directed investors can build their portfolio power. Investing successfully over the long term is not always about “investment alpha” — beating the market — but “process alpha” — following good habits.

In this article, we explore the topic of rebalancing. As you monitor your portfolio, you’ll likely notice that some investments have moved up or down more than others. This is where rebalancing comes in. When you rebalance your portfolio, you return the portfolio to its target asset allocation. For example, say you wanted a portfolio of 70% stocks and 30% bonds but end up with a portfolio of 90% stocks and 10% bonds, because of a stock market boom. In this case, rebalancing is like saying, “Hey, I signed up for 70-30, not 90-10”. We discuss the two most common ways to rebalance, based on time and asset weights. We conclude with an exception for high-flying stocks, where investors might not always want to rebalance.

The most common way to rebalance is based on time, where you rebalance the portfolio at a set interval, such as annually at the start of January. This means that, regardless of whether the market has gone up or down, you rebalance the portfolio at the chosen date. The rebalancing interval typically aligns with your investment horizon. If you’re investing for 10 or 20 years, for example, then annual rebalancing might be appropriate.

Sometimes investors want to rebalance at the perfect time, perhaps with a slight advantage to one season over another, or every 9 months instead of every 12 months. Over the long term, perfect is not attainable. By selecting a rebalancing frequency that makes sense for your investment time horizon and sticking with it, you’ll likely achieve the main point of rebalancing, which is to ensure you don’t end up with much more risk than you intended.

The other common way to rebalance is based on asset weights. An investor manages a portfolio with minimum and maximum weights for each asset. If these minimum or maximum weights are reached, the investor adjusts the asset to its target weight in the portfolio. Here’s an example of this process, applied to a stock portfolio:

Notice these groups of stocks have different minimum and maximum ranges:

• Exciting stock A: Plus or minus 10.00% around the target weight. The investor doesn’t want to rebalance on small or moderate moves, since they expect this stock will move around quite a lot.
• Regular stocks B to D: Plus or minus 5.00% around the target weight. The investor rebalances on moderate moves.
• Stable stock E: Plus or minus 2.50% around the target weight. The investor wants to rebalance on large moves, since they expect this stock will not move around a lot. Large moves would be a reason to take profits or cut losses by rebalancing.

On second thought, the investor decides there are some differences within the group of Regular stocks B, C and D. For Regular stock B, the investor decides to adjust the minimum level from 15.00% to 12.50% — giving more downside room — since they feel this stock is more resilient than the other Regular stocks. For Regular stock D, the investor decides to adjust the maximum level from 25.00% to 27.50% giving more upside room), since they feel this stock has more potential than the other Regular stocks. Here’s the updated plan:

This example shows that investors don’t have to manage each asset in the same way when it comes to rebalancing. It’s really a matter of choosing an approach that works for you, based on the type of investments you hold.

Let’s explore whether to rebalance based on time or asset weights.

Rebalancing based on time can be simpler. The calendar tells you when to rebalance. The process of rebalancing is applied to the whole portfolio. In the above example of the five-stock portfolio, even if only one stock has moved a lot and four stocks have moved a little, you return each stock to its target weight of 20% in the portfolio.

Rebalancing based on asset weights can be more complex. Again, let’s take the above example, where one stock has moved a lot and four stocks have moved a little. That is, the four stocks have not moved enough to reach the minimum or maximum asset weights at which rebalancing would occur. This means you only have one stock to rebalance. What to do with the extra cash? You could invest it equally in the other four stocks, invest it in the other four stocks, pro-rated by their weights, or simply hold the cash and wait for new opportunities.

Rebalancing based on asset weights will likely involve more frequent rebalancing and more investment decision-making than rebalancing based on time. This suggests that rebalancing based on time might be suitable for less active approaches to investing, while rebalancing based on asset weights might be suitable for more active approaches to investing. 

Rebalancing based on time or asset weights can help to manage risk. But sometimes an investor might want to accept more risk, say in the case of a high-conviction stock. The investor expects to hold for a long time and knows from the history of other winning stocks that there can be very large ups and downs along the way — moves that would very likely trigger rebalancing, if the investor were to follow a normal rebalancing process.

In this example, investors can divide their holding of a high-conviction stock between their regular portfolio, where rebalancing will apply, and a “vault” portfolio, where rebalancing won’t apply. Investors lock up their vault portfolio for a certain period, regardless of performance. Sometimes investors set up a vault portfolio as a separate investment account, so that the holdings in the vault portfolio are not mixed up with the activities of monitoring and rebalancing in the regular portfolio. In the strongest cases, the investor may decide to hold high-conviction stocks only in their vault portfolio, not in their regular portfolio.

Rebalancing is a way of managing risk by returning an asset to its target weight in the portfolio. This helps an investor to maintain the level of risk they intended for the portfolio, rather than accept the level of risk the market has provided. 

Rebalancing is typically based on time — like once a year, in early January — or asset weights — when an asset reaches a minimum or maximum weight in the portfolio. Rebalancing based on time may be suitable for less active approaches to investing, while rebalancing based on asset weights may be suitable for more active approaches to investing.

Investors may not always want to rebalance investments with significant long-term potential. Investors can hold these investments in a separate “vault” portfolio, where the asset is locked away for a certain period of time and not included in the regular activities of monitoring and rebalancing.