Portfolio rebalancing is the process of ensuring the portfolio weightings remain consistent with the asset allocation strategy in your investment plan. Assets/positions can become overweight or underweight based on the movements of the markets. The purpose of rebalancing is to ensure you manage risk in correlation with returns and your overall investment objective. Periodically you may need to buy or sell to keep the portfolio within the desired balance.

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What is portfolio rebalancing?

Rebalancing is a crucial aspect of portfolio management. It involves making adjustments to your portfolio’s asset allocation to bring it back in line with the desired balance. The purpose of rebalancing is to ensure that the portfolio’s weightings for each asset remain consistent with your investment strategy.

Rebalancing a portfolio is unique to each investor, as it depends on their investment strategy and portfolio structure. Although there are many financial terms, portfolio theories, and intellectually stimulating ideas surrounding rebalancing, a simple approach can often be the most effective in the long run.

In the Investment Philosophy section, we discussed investment strategy, risk appetite, time horizon, and overall financial goals in great detail. Rebalancing cannot be implemented without first revisiting your investment strategy. Your investment strategy should have an actionable plan for your asset allocation that aligns with your risk tolerance and return expectations.

If you don’t have a strategy that outlines your target asset allocation, you may not know what to rebalance, resulting in an unusual mix of investments. Portfolio management is about ensuring that everything in your portfolio has a reason for being there, rather than randomly selecting assets and hoping for the best.

The simple strategy of rebalancing is to ensure nothing deviates to far away from your target asset allocation. In my opinion, rebalancing is more about managing risk than seeking returns.

There have been a lot of academic studies on the importance of rebalancing in correlation to being a driver of overall returns. A rebalancing strategy can help to have a systematic way to unemotionally make decisions when they matter the most.

Why is portfolio rebalancing an important idea?

Portfolio rebalancing is a crucial aspect of your investment strategy because it ensures that you stay on track with your financial goals. It is important to stick to your plan in the long term, as it often results in successful outcomes.

Changes in the market can impact the value of individual securities, which, in turn, affects their weightings within your portfolio. Over time, some investments may perform well and increase in size, while others may perform poorly and decrease in size. These constant market fluctuations cause portfolios to drift from their intended asset allocation, which can lead to unintended risks or missed opportunities.

It is essential to understand the impact that market changes have on your investment strategy, whether it is conservative or aggressive. For instance, if your financial goal requires a more aggressive growth demand, and you have a higher allocation to stocks than bonds, a decrease in stock prices will increase the weighting towards bonds, creating a more conservative portfolio than you intended. On the other hand, if you are a conservative investor, and your shares experience significant growth, an imbalance towards growth and slightly higher risk can occur. In such cases, you will want to bring your portfolio back to balance by rebalancing.

The beauty of periodic rebalancing is that it forces you to base your investing decisions on a simple, objective standard

Benjamin Graham

At the core of rebalancing is the realignment of your portfolio towards your overall financial objective. Whether your goals demand a balanced portfolio to achieve a certain annual return or a more aggressive portfolio, it is important to ensure that your allocation is designed to achieve your long-term goal.

How to rebalance a portfolio?

Many investors find it challenging to decide when and how to rebalance their portfolios. Frequent rebalancing can lead to unnecessary tinkering which can have negative consequences. Tinkering refers to the constant need to make adjustments to the portfolio, hoping that small changes will contribute positively to the bigger picture. However, this is not always the case. It is essential to consider tax implications, trading fees and the opportunity cost before tinkering too much.

The best approach to investing is a systematic one. Investing systematically helps in making better decisions as it removes emotions and enables a logical and methodical approach to addressing problems as they arise.

Rebalancing too often may lead to the trimming of certain positions, which could result in losses on potential gains. On the other hand, leaving the portfolio unbalanced for too long could lead to underperformance or an increase in risk exposure without realizing it. The objective of rebalancing is usually to sell outperforming positions and reinvest the proceeds in other positions, whether bonds or stocks.

The most common approach to rebalancing is to follow either the calendar rebalancing or trigger-based approach. Although there are several strategies, it is essential to understand that as private investors, we do not have the same complexities or performance metrics to abide by, unlike funds governed by a range of guidelines, position sizings, investment criteria and limitations on cash holdings.

Calendar (periodic) based rebalancing.

Calendar rebalancing is a periodic approach that is usually done every six months or once a year, depending on what you have decided. It is not very efficient or productive to do daily, weekly or even monthly rebalancing as the market tends to fluctuate too much for making long-term trimming and allocation decisions based on short-term swings.

If you have a rebalancing strategy and decide to check your portfolio and rebalance it twice a year, then you should stick to that plan. This is a common approach, especially with passive investing, where an allocation is a mixture of index funds, ETFs, and bonds. It can be quite simple to follow. Many investors check their portfolio once every 6 months or a year, look at the target allocation, rebalance if required, and then log out and go on with their day.

Trigger based rebalancing.

For active investors with a portfolio of individual securities, I find the Trigger-based approach a better option. This is because you may have a 10% threshold that says positions or weightings can not diverge from the target allocation by more than 10%. This means when it nears that target trigger, you can rebalance. The trigger position can also be laid out in several ways.

For example, you may have a portfolio that says you will hold a diversified mix of between 20-25 positions. Allocation to large-caps, small-caps, and some overseas companies. Each of those segments of the portfolio is assigned a weighting. When that dislocates, rebalance. You may say, “I will have a portfolio with each position not allowed to grow to more than 10% of the portfolio,” which would trigger a rebalance.

So the idea of rebalancing will be clearly defined around the asset allocation, weighting to each allocation, and then your guiding principle. The guiding principle may be “I will rebalance once per year at the beginning of tax time” or “I will rebalance when one position becomes more than 10% of my portfolio” or “I will rebalance when my overall asset allocation has drifted by more than 5%”.

This helps to follow a systematic approach rather than keep on adjusting constantly.

Rebalance when the portfolio is out of balance…

I could summarise the entire blog by answering one question that always comes up “When should I rebalance my portfolio?” To which I always respond “When it is out of balance”. Have a strategy up front that governs this and this will drive all decisions. You should not be investing in anything without a plan.

So, whilst I may sound very repetitive in this blog, I’m trying to drive the idea home. Rebalancing in itself is pointless if you have no plan.

Identify your financial goals and then risk appetite. Design a portfolio of assets that can help facilitate this objective. Then rebalance the portfolio when the assets start to drift from that objective. If your goals change realign the target asset allocation to those goals.

Don’t tinker. This is counterproductive to the purpose of wealth creation. A lot of investors create portfolios to build wealth and be financially free and independent. Then they become a slave to checking their portfolios, anxious about market movements and tinker to the point of diminishing returns.

I like the rebalancing strategy with a schedule designed around whatever is happening in the portfolio. This means you avoid timing the market, you are responsive only when you target allocation has drifted and that triggers the rebalance.

Should all investors rebalance their portfolios?

Whilst rebalancing can serve a purpose in a lot of portfolios it may not be suitable for others. For example, I am an active stock picker. I am focused on finding good quality companies, with long runways of growth ahead. They are predominately smaller businesses. I want to find and own companies over long time horizons. If I also find undervalued opportunities I may also take a position. The goal is to make money.

I am also very concentrated on my best ideas. I don’t limit my portfolio to a certain number of positions. It is concentrated as it is designed around conviction levels and usually remains below 10 positions. So, in saying this, placing a rebalancing strategy on what I do can become difficult. Sometimes I am in a couple of positions and a lot of cash, sometimes I am fully deployed. I’ve had positions become 90% of my equities portfolio until they deserved to be sold.

The outcome is to compound capital. The idea of rebalancing on a portfolio like mine is not ideal. It means when positions run to a size I would have to trim them. However, I don’t want to do that. I let them ride, as long as the thesis remains intact. Where I would rebalance is more so on an individual idea not based on percentages or annually.

When the thesis breaks on an idea or perhaps when a better idea presents itself and the opportunity cost warrants my attention, I “rebalance” to accommodate it. If I believe a company can no longer deliver the thesis, I exit it to “rebalance” that capital elsewhere. So I don’t have a rebalancing strategy laid out in gold but indirectly it is followed based on my criteria and philosophy. Just another idea to think about.

An example of rebalancing.

Suppose you are using the threshold-based approach to rebalance your portfolio. This strategy suggests that you should trigger a rebalance when your portfolio or any asset class deviates from the target by more than 20%.

To design your portfolio, you want to have a higher allocation to growth as you have a longer time frame and want to compound capital. You decide to hold 20% of your portfolio in bonds that produce income, have liquidity and are a great risk hedge.

You also want to capture the top end of the world’s biggest markets, but you don’t think you can beat the market in general in large caps. So, you buy a couple of index funds to create the core of your portfolio and give them a 50% weighting. You keep 10% aside in cash for opportunities. This leaves you with 20% to allocate to a high-growth small-cap “satellite” portfolio.

You assign 20% divergence to each of the asset classes, as follows:

• Bonds 20% = Rebalance if moves +/- 4% of the total portfolio.
• Index Funds 50% = Rebalance if moves +/- 10% of the total portfolio.
• Small-Cap Stocks 20% = Rebalance if moves +/- 4% of the total portfolio.
• Cash 10% = Rebalance if moves +/- 2% of the total portfolio.

For example, if Index funds went on a bull run and crept up to 60% of the portfolio, you would sell down 10% and reallocate it to the parts of the portfolio that were underweight this target allocation.

Similarly, if small-caps took a pounding in the market and dropped to 16% of the portfolio, you would sell down the other asset classes to achieve their target allocation, which would bring the balance back to the small-caps by allocating the sold securities to this underweight asset class.

A thought-provoking idea around rebalancing.

I know a lot of very wealthy investors, ultra high nets who’ve made a lot of money in markets and investing in general. They ALL, not one, but ALL raise eyebrows at these types of ideas. They don’t follow a guide that says I will only keep X amount in this X amount in that and X amount in this.

Their approach is to move money around where they see opportunities, sometimes diversified and sometimes highly concentrated. I bring this up to only encourage you to think about the bigger picture. As Stoic Investors, we want to create wealth, and wealth can never be achieved by following normal practices.

Hang on, we are not wealthy individuals you may say. However, they, including myself never made money following the normal academic path to begin with.

Rather than think about rebalancing in a confined way, think about rebalancing from an opportunity cost perspective. When a better opportunity or a high-conviction idea presents itself, rebalance to make space for it.

If a fantastic idea came up, had the right fundamentals, and you understood all aspects of the business model and had conviction in the long-term outcome. You have to be prepared to load up, this throws the entire portfolio out of balance. Yes, it can present some risk but “risk comes from not knowing what you’re doing” (Warren Buffett).

I’m not refuting the idea of rebalancing in any way. It is a great strategy and makes sense for most investors, but don’t let that paralyse you and draw your attention to tinkering and getting fixated on minor details. Know what you want to do, know what you want to own, and then aggressively look for the best in class.

In Summary…

Portfolio rebalancing is a broad topic, and I have not elaborated on it in detail here. Like all investment concepts, it can be as simple or complex as you make it. The best approach is to stay updated with your portfolio and keep track of any deviations from your target allocation. If you notice such deviations, take corrective action. Keep in mind, rebalancing more frequently is counterproductive.

It takes experience to get portfolio rebalancing right. Sometimes, selling stocks based purely on a percentage movement may mean that you end up selling a multi-bagger. On the other hand, selling a winning stock to top up a poor performer may mean topping up a dud. Before making any rebalancing decisions, especially on individual stock selection, ensure that the underlying fundamentals always warrant additional capital. Otherwise, why invest in it? A good approach can be to sell winning investments in an asset class and then use the proceeds to top up underweight positions in another asset class. For example, from stocks to bonds.

As this site is more focused on active stock selection or stocks in general (including ETFs and Index funds), the strategies may not always align with modern portfolio theory and the very academic approaches to making money that theoretically always works.

The concept of rebalancing is more suited to portfolios that hold a range of asset classes from bonds to index funds, and within each asset class, there will be large-caps, small-caps, or whatever diversification strategy is required.