Rebalancing for fun and profit

By Slow Dad - November 05, 2016

Asset allocations diverge over time, some investments gain value while others lose it. Read why rebalancing is vital to securing long term success.

Everything perfectly in order?

Many investors lurch from one “next big thing” to the next, unquestioningly acting on tips from their acquaintances or the financial press.

Some investors divine animal entrails, read tea leaves, apply philosophical biases, or otherwise seek guidance from the money gods about investment selection.

Less impulsive investors carefully research their investments, gathering sufficient evidence to convince themselves of an individual investment’s merit.

Others outsource investment selection accountability to a financial advisor, who is more knowledgeable or perhaps just more confident than their fee-paying client. The quality of the advise may vary, but the client feels good about having somebody else to blame.
All portfolios need a periodic review and rebalance.
Periodically review and rebalance your portfolio
Whatever the investment selection method, there comes a time when all investors must critically assess their investments holdings. Over time asset allocations will have diverged, as some investments gained value while others lost it.

Change is constant, nothing lasts forever

Consider the case of Apple shares. Over the last 10 years their value has increased more than 800%. That increase may now mean that Apple accounts for a disproportionately large portion of the investor’s overall portfolio.

Apple share price over the last 10 years.
Fluctuating values may skew asset allocations
Once the investor becomes aware of these portfolio imbalances, they may wish to reallocate funds to bring their portfolios back into alignment with their preferred asset allocation. This process is called rebalancing.

The act of rebalancing is counter intuitive. Sell some of the winners to buy more of the losers.

Sell some of the winners to buy more of the losers.

WTF?!? I hear you exclaim. You want me to keep throwing good money after bad?
Good money after bad.
Good money after bad
Yes. Yes, I do.

The idea behind this approach is simple: what goes up must come down.

Equally true is the old investment success maxim of “buy low, sell high”.

The investor takes a profit from investments that have appreciated, and reinvests those profits into investments that are perhaps undervalued or will likely experience a similar rise in the future.

Warning: some thinking is required

A note of caution here, some common sense is required. I appreciate this may be considered a super power these days. As any husband can attest, “once you’re in a hole, stop digging”. The same is true of investments.

Investing in low cost index trackers helps make these decisions easier by removing much of the emotion potentially involved.

My personal approach is to review my portfolio allocation monthly.
  1. I compare my target weightings to my current portfolio allocation, and identify imbalances.
  2. I harvest any cash over my budgeted cost of living and emergency fund needs.
  3. I invest that surplus into those assets where I am currently under my target weighting.
Annually I rebalance my portfolio by selling down overweight assets to reinvest in underweight assets, restoring my target asset allocation.

Rebalancing via asset sales incurs a higher transaction cost, with brokerage payable on both the sale and subsequent reinvestment. Capital gains tax may also be incurred on the sale. Deploying new funds in this way results in a regular partial rebalance, without all the costs.

So what?

The effectiveness of this regular partial rebalance approach reduces as the portfolio value grows, due to the diminishing materiality of the additional monthly investment.

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