Rebalancing Your Portfolio

Introduction

In this blog we are going to discuss how to rebalance a portfolio using two key Stock Rover tools: Portfolio Analytics and Portfolio Rebalancing.

Note: Portfolio Analytics and Portfolio Rebalancing are available with the Premium and the Premium Plus Stock Rover subscription plans.

Rebalancing is used when the model portfolio has a certain well-defined allocation of positions (stocks, ETFs and/or funds) by percentage. The Stock Rover Rebalancing Tool shows the model percentages and how far the actual portfolio has drifted from the ideal balanced portfolio as well as the trades necessary to bring the portfolio back into balance.

When to Rebalance

One of the key questions that comes up with rebalancing is how often to rebalance. There is a lot of academic and financial literature on rebalancing; I think it is safe to say that there is no universally agreed upon one right way to rebalance – the strategy employed for rebalancing a portfolio is an area of wide latitude for investors.

There are two basic rebalancing strategies. They are to rebalance on a schedule or rebalance on excess-drift from the model. Within each of these strategies, there are endless variations.

For example with schedule based rebalancing, the periods can vary considerably. Yale University is legendary for rebalancing their endowment daily. For an individual investor, normal periods are every quarter, every six months or every year, with every year probably being the most common and the easiest for investors to implement realistically.

The other option is to rebalance on an excess-drift percentage from the model portfolio. Depending on what the portfolio actually owns, which in turn defines the portfolio’s volatility and asset dispersion (i.e. different assets performing differently), this can result in anything from frequent rebalance events to almost-never rebalance events. Common excess-drift tripwire values are drifts of 1%, 2%, or 5% from ideal. If you use the excess-drift method, the portfolio will need to be checked fairly frequently to see whether any drift tolerances have been violated by any of the portfolio’s assets.

A common strategy for investors is to rebalance once a year and only rebalance if the drift, which is the difference between the ideal allocation and the actual allocation, exceeds 1%. However, really any reasonable strategy is worthwhile, as they all drive the same behavior, which is checking a portfolio’s balance periodically and ensuring the portfolio has a corrective means from becoming too unbalanced.

Rebalancing Risks

Ironically, studies have shown that in general, the less you rebalance, the better your portfolio performs, albeit with increasing risk. The reason for this counterintuitive result is momentum, coupled with, well, lack of balance. Or in other words, an overallocation to securities that are performing well and an underallocation to securities performing less well.

The risk part comes from the winners becoming a bigger part of your portfolio and then if/when their momentum falters, they will negatively impact the overall return of the portfolio more than they normally would because of their higher-than-ideal weighting.

Rebalancing more often negates the stock price momentum effect and outsized weighting effect at the cost of possibly losing the momentum tailwind. Other disadvantages of rebalancing more frequently are trading costs, tax costs and effort required to maintain the portfolio. All three of these factors increase with more frequent rebalancing.

Our Model Portfolio

For the purposes of this blog entry, I created a model portfolio one year ago called the Select Sectors Portfolio that allocated 25% to each of four different sector ETFs. Two of the sectors were in offensive sectors: Technology and Health, and two in defensive sectors: Staples and Utilities.

Using Stock Rover Analytics, and looking at the screenshot below, we can see this portfolio has done a really nice job over the last 12 months, outperforming the S&P 500, while doing it taking less risk. Which, believe me, is no easy task. So this portfolio can feel free to high five itself.

Looking at the performance of the individual components of the portfolio, we see the following:

We see that the bulk of the portfolio performance has come from Technology and Utilities, with Staples doing well and Healthcare, while positive, lagging in relative return.

This has the feel of a portfolio that is ready for rebalancing under the guise that momentum works until it doesn’t. And under the flag of reversion to mean, the implication is that Technology and Utilities are likely to fall back to a more sustainable price performance level of return. This in turn implies that at some point there is likely to be rotation towards some of the underperforming sectors. We will rebalance to try to get ahead of these potential winds of change.

Rebalancing

Rebalancing in Stock Rover is really easy. We start by taking the portfolio as is in the rebalancing tool, as shown below.

We then ensure the “Plan By %” box is checked, as highlighted below. Then we drop in our 25% allocations to each of the components of the portfolio directly into the table cells under the “Planned Value (%)” column. From that we get the following rebalancing plan, as shown below.

Note that we are using zero drift (also highlighted) meaning that if the actual portfolio deviates from the model rebalanced portfolio by any non-zero tradeable amount (i.e. at least one share), then a planned trade is generated.

Now we see how easy it is to rebalance. We just go to our brokerage house, log in and perform the following four trades in the portfolio:

• Sell 239 shares of XLK (Technology)
• Sell 202 shares of XLU (Utilities)
• Buy 132 shares of VHT (Health)
• Buy 163 shares of XLP (Staples)

Rebalancing With Non-Zero Drift

Let’s try a slightly different approach where we rebalance only if the drift from ideal exceeds 1%. This is easy to do in the Rebalancing tool by just setting the drift tolerance to 1 as shown below.

Now we can see that the recommended trade of buying the XLP ETF (Staples) drops out since that position is within one percent of the model portfolio. The other portfolio components are not within 1% of the model, and those recommended trades remain. Interestingly, doing these trades will free up $9,871 of cash. That cash could remain as cash, or could be used to buy XLP to get it from its current 0.9% deviation from ideal to ideal. This would be the investor’s choice.

One thing to be aware of is with drift tolerance set at a non-zero value, trades can generate excess cash or negative cash. In the latter case, the likely response to prevent this would be to perform sales on the overallocated positions that would generate the needed cash, even though they are under the drift level for rebalancing.

Note that if we use a 3% drift, then all our trades disappear and we would just sit on our hands and let our portfolio run, as shown below.

Final Thoughts

Rebalancing is a powerful tool in an investor’s arsenal to help achieve better risk-adjusted portfolio returns. There are a wide variety of approaches that can used for rebalancing. The Stock Rover Rebalancing Tool will be helpful in any rebalancing endeavor, regardless of which rebalancing approach you actually decide to use.

I’ll end this post with one final investor’s maxim:  “Rebalance, but not too often”.