It's easy to spend all your time as an investor worrying about hunting down your next big trade. But regular portfolio maintenance and rebalancing is just as, if not more, important. Here's why.
What is rebalancing?
Rebalancing is one of the simplest principles in investing, but it is easily overlooked. The idea can be applied at an overall portfolio level, or at the level of specific asset allocations, say to individual shares. So for example, at the overall portfolio level, you might decide that your preferred way to divide £100,000 of savings is to put 60% in stocks and 40% in bonds (in case you're wondering, these percentages are purely for illustration this isn't a recommendation).
Let's say share prices rise for a few months while bonds remain largely flat. So now your shares are worth £70,000, while your bonds have stayed at £40,000. That means that shares now account for 64% of your portfolio, while bonds have dipped to 36%. So assuming you want to stick to your original asset allocation plan, you need to sell some shares and buy some bonds. To get back to 60%, you would sell around £4,000 worth of stocks, leaving you with £66,000. That £4,000 can be used to buy bonds so that you now have around £44,000 in bonds (44/110 as a percentage is 40%).
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Alternatively, you might decide you need the £10,000 profit you've made on your shares for something else altogether (a sudden tax bill, perhaps). In this case you would simply sell the £10,000 of shares, which would take the portfolio back down to a total value of £100,000, split 60:40.
The same principle can be applied within your portfolio to individual stocks or bonds, so that you maintain the same weighting in any one particular stock at, say, a steady 5% of the equity portfolio. But is it worth all the effort?
Is it worth it?
Pick the wrong short-term time horizon and the answer is no, according to Morningstar data. For example, according to The Wall Street Journal, if you'd invested $10,000 in a 50:50 mix of stocks and bonds in December 1993, and just left it at that, then by December 1999 you'd have been sitting on $24,419. By September 2002, in the wake of the dotcom crash, you'd have been left with $19,240. Had you made the effort to rebalance annually you would still have ended up "with almost the same result". But you'd have wasted time and money in the process (we'll get to costs later).
And rebalancing would have been a disaster after the crash of 1929. Had you rebalanced the same 50/50 portfolio during the period from the stockmarket peak in autumn 1929 through to June 1932, you would have lost 48% of your portfolio's value, against 35% if you had just sat back and left it untouched.
When it works well
However, what all these studies really reveal is that if you take a short enough time frame, then almost any stockmarket technique can flounder. As Janet Brown points out on Forbes, rebalancing has worked well in this downturn. From 2007 to 2009, an unbalanced portfolio that started off with a 60:40 split would have lost 37% against 30% for a rebalanced equivalent (based on comparing the S&P 500 index for stocks against the Barclays Capital Aggregate Bonds index).
But you need a longer view to see rebalancing working best. As the chart shows, for the 25 years from 1985 to 2010, "the rebalanced portfolio ended with a higher return: a $10,000 investment became $97,000 versus $89,000 for the un-rebalanced portfolio". Brown also notes that rebalancing protected investors better during the deepest stockmarket decline. This is important if you are exposed to any high-risk investments in your portfolio.
As Dan Caplinger points out on Motley Fool, anyone who put 5% of their share portfolio into hot internet stock Netflix at the start of 2010 would have paid $55 per share. At its highest point, the share price rose to more than $300. That would have increased its weighting in a portfolio to more like 22%. So what? Well, had you rebalanced then, the fact that the shares have crashed back to $69 since would've been less painful. A more extreme case is resort firm Las Vegas Sands: a 5% allocation in March 2009 would now account for around 62% (based on a 2,997% total return) of your portfolio, assuming all the other shares remained static over the same period. In short, without rebalancing you can seriously skew your risk exposure.
Beware of the costs
There's one problem with rebalancing regularly: each time you do it, you'll take a hit for costs. If you move money from one share into another, you'll be hit for two sets of bid-to-offer spreads and dealing costs. And it requires more effort first to work out how much to buy and sell of a specific share and then to ensure it happens than doing nothing.
So the trick is to rebalance regularly, but not too often. You could mimic fund managers and go for a quarterly rebalance, but we think, given the cost, that's far too often. An annual review, on the other hand, should serve you well. With the end of a torrid year in the stockmarket approaching, what better time to do it than now?
This article was originally published in MoneyWeek magazine issue number 569 on 23 December 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.
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Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.
He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.
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