John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
The investing world is so often focused on the next, big, exciting thing. But more often than not in investing, it's not the big, sexy moves that lead to good long-term returns. It's the little things – things like rebalancing your portfolio on a regular basis.
Rebalancing is the process of selling off some of the holdings that have grown beyond their target weightings, and buying more of those that have fallen below their target weightings. Two different types of rebalancing can help you greatly over the long haul.
The first is rebalancing between asset classes. Say you want to have 65 per cent of your portfolio in stocks, 30 per cent in bonds, and 5 per cent in gold. Depending on how each class rises or falls, your actual allocation will change. The most obvious reason to perform this kind of rebalancing is that you don't want your asset allocation to get too far out of whack with your risk tolerance.
But there's another big benefit: Rebalancing can actually increase your returns. The Wall Street Journal recently highlighted a study done by Columbia Business School Professor Andrew Ang. The study looked at two distinct periods (1926-1940 and 1990-2011), each of which included one of the worst declines in U.S. stock market history. He found that a portfolio of 60 per cent stocks and 40 per cent bonds, rebalanced to those weights quarterly, significantly outperformed an all-stock portfolio and an all-bond portfolio.
This occurs because rebalancing essentially forces you to sell assets that have risen in price, and buy those that have fallen. And, given the powerful force of reversion to the mean that acts in the market doing so tends to work out well. Stocks, for example, tend to be extremely volatile in the short-term but for well over a century have come back to long-term average returns of 8 per cent to 10 per cent per year.
It's just the opposite of what our performance-chasing emotions tend to tell us to do, which often gets investors into trouble.
The other type of rebalancing involves rebalancing individual holdings within the equity portion of your portfolio. This keeps a hot (and possibly overvalued) holding or two from taking up an outsized portion of your portfolio. You can also rebalance between differing equity portions of your portfolio – if, say, the emerging markets portion gets too high or too low, you can rebalance it to a target weight.
With the Guru-inspired portfolios I track on Validea.com, I use my rebalancing dates not only to bring each portfolio's stock holdings back to equal weight, but also as the one day a month that I make trades. On these predetermined dates, I essentially drop the stocks that are no longer among the highest scorers and replace them with stocks that are.
The 14 model 10-stock portfolios I track have averaged annualized returns of 9.7 per cent when rebalanced monthly over the decade-plus that I've used them. Quarterly rebalancing has led to an average of 8.8 per cent, and annual rebalancing an 8.0 per cent annualized average. The results have been similar for my 20-stock portfolios. Keep in mind these returns don't include dividends and trading costs.
Other factors besides raw returns certainly factor into a rebalancing plan. Trading costs are higher the more frequently you rebalance (though inexpensive online trading options make this less of an issue than in the past), and longer holding periods can mean better tax rates. Depending on the specific strategies you use, an annual or quarterly rebalancing may be better than a monthly approach.
But the key, in my opinion, is picking a rebalancing period and sticking with it. In doing so, you are generally forcing yourself to buy cheap assets and sell expensive assets, which is a recipe for success.
Moreover, if you do all of your buying and selling and rebalancing on the same preset days, it does a lot to take emotion out of your investing process. You buy and sell only on those days – not when you read a scary or exciting headline, see short-term price fluctuations, or have a "gut feeling," all of which are actions that usually wreak havoc on investors' portfolios.
Adopting a fixed rebalancing period may not seem nearly as exciting as investing in the next hot IPO, but it's likely to do a lot more for you in terms of generating exciting long-term returns.
John Reese