On Tuesday, I discussed stock portfolio diversification and how a few holdings can provide big benefits. Today I want to address the portfolio’s dynamics, once the different holdings begin to alter their allocations because of dissimilar performance results. The main question is, “Do we rebalance the positions back to their original allocations, or do we let them wander, driven wherever investor demand and supply takes them?”
Before discussing that question, a word about the rebalancing process:
For your total portfolio, you probably know the drill: Evaluate your needs and risk tolerance, then choose the asset allocation that best fits you. For example, you might decide that 10% money market fund, 30% bonds and 60% stocks gives you the potential return and risk control you desire. Depending on how those assets are managed, the bond and stock allocations might be subdivided by investment management approach – e.g., growth and value for stocks.
Once your portfolio has been set up, you then track your allocations. Your allocations can change as the markets move, causing your portfolio risk/return characteristics to shift. Therefore, you periodically need to “rebalance” back to your desired allocation levels by trimming overweight areas and bolstering underweight ones.
Now, let’s discuss that portfolio of stocks. Certainly they will not all go up and down in lockstep, so weightings will change. Do they then need to be periodically rebalanced also?
Theory and academic studies support rebalancing if you tend to hold positions for the long run. Without rebalancing, outperforming stocks can take on an inordinately large position while underperforming ones shrink. This imbalance skews the portfolio’s risk to the larger positions and diminishes the diversification effect.
The graph shows the cumulative performance index for each of the four stocks I have been discussing, along with an equal-weighted (each holding is one-fourth) portfolio. Rebalancing occurs every month.
The first thing to note is how well the portfolio tracks the Dow Jones Industrial Average (DJIA), even as the stocks follow different paths. This is the diversification benefit I described yesterday, maintained by the rebalancing.
However – there are sound reasons for not rebalancing.
Transaction costs. Unless your portfolio is very large or you have access to inexpensive trading, normal transaction costs can eat up much of the diversification benefit.
Taxes. Selling in a taxable account can produce taxable gains and losses. These taxes can also reduce the diversification benefit.
Security diversification is not the same as asset diversification. We know that picking securities is an uncertain activity, and that not all will work out as we expect. There are popular sayings that argue against rebalancing, such as “Don’t throw good money after bad.” Some go further, arguing for pruning out the underperformers, such as “Sell your losers, and let your winners run.”
I have seen both rebalancing and non-rebalancing approaches work. It really comes down to what you’re most comfortable with. We can envision situations where rebalancing and not rebalancing work well and poorly. For example, rebalancing to underperforming bank stocks in 2008 (or, worse, Lehman Corp.); or not rebalancing from high-flying internet stocks in 2000.
Using our four-stock example, let’s see how a non-rebalanced portfolio compares to a rebalanced one.
Because the stocks seesawed through the last five years, with no clear trend leader, the rebalancing added some value. However, in a growth period, a leader or two could emerge, pulling the non-rebalanced portfolio higher.
My preference is to use rebalancing for asset categories only, adjusting individual holdings only when there is a special reason to do so. In the two examples I cited above, the answer is to be wary of fads and problem stocks, and not let price moves, alone, determine whether to buy or sell.
Disclosure: No positions