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You worked hard to balance your portfolio by carefully deciding how much money to allocate for defensive, growth, and dividend stocks of various market caps. Three months later it is 'out of whack' and your advisor wants to put everything back into the proper weights. This makes sense since your small-cap growth portfolio has grown and its increasing size means increasing risk. Time to sell some shares in those hot stocks and beef up that portfolio full of out of favor laggards that have shrunk in value. But is this rebalance a good move?

Re-balancing and Momentum

Re-balancing your portfolio can be a great way to maximize gain and lower risk…if you do it correctly. But if you are going to hold a static basket of stocks and mere shift money around between firms in order to maintain weights, you may inadvertently do one of two things: handicap your winners or feed your losers. Why?

Well, momentum is a proven effect all equity markets around the world except Japan (see Size, Value and Momentum in International Stock Returns). The concept is that lagging stocks which greatly underperform the market over the past quarter to year tend to do again so over the following year. Those that beat the market over the past quarter to year tend to outperform the market over the following year.

Don't Put Your Apples in the Bank

It doesn't take a lot of imagination to realize how a rebalancing strategy can work against you. To make it simple, imagine a two stock portfolio with Apple (AAPL) and Citigroup (C). Over the past year Apple is up 60% and Citigroup is down 28%. If you invested $100,000 in each company you should have made $33K profit or 16%…if you didn't rebalance.

Charts compliments of Portfolio123:

click to enlarge

If you rebalanced every three months your gain would drop to 10.4% as the losing stock kept gobbling up the winnings. That is one hungry banker. (Red line is your two stock portfolio and blue line is the S&P 500)

Google Teams Up with AT&T...Sort Of

There are other times that this sort of re-balancing might work in your favor though. What if you had to high performing stocks that were advancing at different times? In this case you might just hit it right and move funds from a stock after a healthy run-up into another great stock that hasn't yet flew.

Similar to this is the process of choosing stocks that have low correlation to one another and are not plagued by negative momentum. The numerous tests I have run, however, shows only marginal gains from this sort of rebalancing even when trading two products that are fairly dissimilar.

Google (GOOG) and AT&T (T) have a trailing one year correlation of 46%. These two stocks have been trading somewhat independently from each other. If you only rebalanced once a year with these two stocks, your total 5 year gain would be 12.9%. If you rebalanced every 3 months your total gain would jump up to 19.7%...and this is some of the better numbers that I can find.

Is the 1.36% annual excess gain worth the trading fees and slippage costs for rebalancing four times as often? My guess is no. Often it results in a much smaller gain and I can't imagine that being worth the hassle. I've ran this using equal weighting strategies buying everything in the S&P 500 (SPY) as well as numerous other indexes and the answer is pretty much the same. If you want to make a case otherwise, I am open to discussion.

When Re-balancing is a Great Idea

Does this mean that rebalancing is a bad idea? Not at all. Studies are starting to find a link between rebalancing and a certain type of dividend growth with deep value and superior gains. These principles are used in the Dogs of the Dividend Aristocrat portfolio which my next article will dig into and reveal how regular rebalancing of these value stocks actually lets your dividend growth run faster than glamour stocks with high dividend growth…and why.

What has been your personal experience when rebalancing your equity portfolio (and I am talking about re-weighting existing stocks and not new positions). I would like to hear your side of the story.

Source: How Not To Re-Balance Your Stock Portfolio