Should you rebalance according to a fixed schedule or a fixed threshold?

The thorny issue of rebalancing a stock portfolio is something we’ve been looking at closely in recent weeks. It’s a subject that matters more to some investors than others. Stock market hunters often recoil in horror at the idea of selling winning positions and buying laggards. But for the rules-based “farmers” who build portfolios to harvest value and momentum premiums over the long term, rebalancing is much more important.

Why is it important? Well, rebalancing is part of the precarious art of managing risk. Keeping your positions in line with their original target allocations profits from a phenomenon known as mean reversion. In simple terms, this means that shares that have roared ahead may fall back down, while those that have so far underperformed (assuming they still meet your strategy rules) could well eventually rise. Ultimately, it’s about the Robin Hood approach of systematically taking from the rich and giving to the poor and remembering that, regardless of your strategy, it may take considerable time to fully ‘out’ the value of some shares. In The Little Book That Beats the Market, Joel Greenblatt puts it like this:

“Even superior investment strategies may take a long time to show their stuff. If an investment strategy truly makes sense, the longer the time horizon you maintain, the better your chances for ultimate success. Time horizons of 5, 10, or even 20 years are ideal.”

Investors are routinely drilled on the importance of rebalancing but the single most important factor in deciding on how and when to do it is costs. Depending on individual circumstances, trading shares can rack up crippling broker fees, crystallise capital gains taxes and the wide spreads on some shares can also eat into profits. We previously looked at the costs of rebalancing and how their compounding effects can destroy your long term investment returns. So it’s essential to figure out how these costs will impact your returns long before you start thinking about rebalancing your positions. But once you have, there are a few ways to tackle it…

Calendar rebalancing

Some of the most common advice is to rebalance according to a fixed timetable, such as every six or 12 months. In theory this helps to maintain the discipline of routinely looking at how the shape of a portfolio has changed. On the rebalancing date, in a rules-based strategy, new candidates that qualify for the rules will be bought, while those that no longer qualify will be sold, while of the holdings that still qualify, the winners are trimmed back and the funds are channelled back into the rest.

Deciding on the precise time-span between rebalancing dates comes down to various factors but especially those that impact the costs of rebalancing - portfolio size and tax status.

Threshold rebalancing

Another common approach is to rebalance only when individual stocks get way out of whack from their original target allocation. Regardless of whether the threshold is to reduce positions when they become greater than 5%, 10% or 20% of your portfolio, you’re basically letting the portfolio guide the rebalancing decision rather than waiting for a specific day in the year. This is a more proactive and risk-averse approach than calendar rebalancing because it acts quickly to stop a portfolio becoming too heavily weighted in individual stocks. However, in portfolios of particularly volatile stocks it could lead to excessive trading.

Calendar & Threshold rebalancing combined

A potentially happy medium is to apply threshold rebalancing on a fixed timeframe. In other words, review the portfolio periodically and only rebalance the stocks that have moved beyond the pre-set thresholds. Depending on the size and nature of the portfolio, this could help limit the trading costs that might be incurred by simply relying on threshold rebalancing, while allowing room for individual positions to grow before clipping their wings. Again, it depends on the nature and the volatility of the stocks in the portfolio.

Tactical top-up rebalancing

A fourth rebalancing option is one that applies to investors who regularly deploy new funds to their portfolio (perhaps making use of the annual ISA allocation), as well as those that re-invest dividend income. In this instance the new funds are directed at hitherto underperforming stocks (again, assuming that those shares still qualify for the strategy rules). The advantage of tactical top-ups is that they can partially, or even fully, rebalance the portfolio without incurring any of the costs of having to sell down positions first.

In the case of re-investing dividends, care is needed. Because most income investors pay very close attention to high yield, it’s worth considering where dividend income should be distributed in the portfolio. Stocks that have risen strongly in price may have seen their yields fall, whereas lagging stocks may have seen their yields rise (although that depends on whether the dividend per share on each stock has changed). If this is the case then directing cash at underperformers rather than outperformers can still make sense - as long as a dividend trap hasn’t emerged in the portfolio. Either way, it’s an extra dimension worth thinking about.

Costs are crucial

Ultimately, the precise ‘how’ and ‘when’ of rebalancing comes down to personal preference and risk tolerance. It’s important to remember that keeping control of allocations is one way of managing risk. But without keeping a very close eye on the costs, all the theoretical benefits of rebalancing could be swallowed up.

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