A Word About Portfolio Rebalancing

On Tuesday’s Bloomberg Surveillance show, Tom Keene referenced some of my bullet points from Keep Investing Simple. (One bullet was to Ignore the Chattering Class, but I was not referring to Tom, whom I have a great deal of respect for).

Live TV being what it is, we briefly touched upon rebalancing, but gave it short shrift. A few emails from viewers and a comment from Econochat later, it is clear that I muddied the waters rather than clarifying them. This post will hopefully correct that misadventure.

Whenever I reference rebalancing, I am referring to asset classes — Equities, Bonds, Real Estate, Commodities, etc. It does NOT refer to individual stocks.

Take a portfolio model of 60% equities 40% bonds (60/40) primarily held through broad ETFs. After there was a hypothetical big quarter for bonds and a weak quarter for stocks, your 60/40 portfolio ends up looking more like 58% Equities and 42% bonds. The market action has led your holdings to drift away from your allocation. Rebalancing means that you are returning back to your original asset allocation model weightings.

Why do this? Because history teaches us that all broad asset classes will eventually mean revert. The goal of the rebalance is to take advantage of the short term volatility and price swings to move you back towards your model 60/40 allocations at more advantageous valuations.

In practice, it means you trim your bonds holdings after they had a good run and you buy equities after they have fallen. If you have more asset classes, you do the same, rebalancing to your model. A typical allocation may be that are 62% equities 31% bonds, 4% Real estate and 3% commodities 62/31/4/3. On a regular basis, quarterly, semi annually or annually, you rebalance back to your original allocation.

50/50 is a very conservative allocation, 60/40 more  moderate, 70/30 more aggressive, 80/20 even more so. The original allocation decision you make is a function of your risk tolerance, assets, and time horizon.

If you own Berkshire or Visa or JNJ (as we do) and they are working, you lock them in your portfolio and let them run. With individual stocks, you DO NOT rebalance — but eventually, you may have to make a sell decision. That is an entirely different conversation.

Asset classes mean revert. Any stock can go to zero, but an asset class cannot. And the reason to own an individual name (versus an index) is that it has the potential to outperform that broad index. That’s why you DO NOT rebalance them — it defeats the primary purpose of owning individual companies.

This piece is cross-posted from The Big Picture with permission.

One Response to "A Word About Portfolio Rebalancing"

  1. Isaac M. Goodwin   April 16, 2013 at 2:28 am

    I have read this article "Rebalancing Your Portfolio" and it talks about how rebalancing works. Well, there are two ways to rebalance a portfolio. First, is to use new money to allocate it to your assets or asset classes. The second is to sell enough of the 'winners' to buy more underperforming assets. Sounds counterintuitive but it is one of the significant ways to maximize investment benefits.