Re-Balancing of investment portfolios can to many amateur investments seem counter intuitive. If you’re not familiar with the concept re-balancing an investment portfolio is the act of returning the funds held back to the proportions in which they were originally purchased.
So imagine you have a portfolio of just 2 funds. Fund A and Fund B. Initially you bought £50 of each. But after a year Fund A is worth £175 and Fund B is worth £25. Now to ‘rebalance’ we would sell £75 of fund A and with the proceeds buy £75 of Fund B so that now we have £100 of each.
As you can see this usually means selling funds that have done well and using the proceeds to purchase more of the funds that have not done so well.
So on the face of it you’re selling your winners to buy losers? That can’t be right can it?
Absolutely it is and in the rest of this article I’m going to explain exactly why professional investors do this.
There are two key reasons that we would be ‘re-balancing’ an investment portfolio.
The first, “Buy ‘em cheap and sell ‘em high” has been the aim of all investors since the dawn of markets. It’s how one would really make money by selling things that have achieved a high value that you bought when they were a lower value.
Unfortunately human instinct is actually to buy things that are doing well already and ignore the things that aren’t currently doing well.
Now if your portfolio of investments is diversified – meaning that they have been deliberately selected to not react to markets in the same way – it is expected that when one is doing badly another will be likely doing well. And as positive and negative runs never last forever then rebalancing at the right time means you are selling one fund on a high and buying the other cheap! The aim of most professional investors.
The second reason is managing and maintaining a specific risk profile.
If we go back to the Fund A/B scenario above, imagine fund A is risk rated 1 and fund B is rated 10 on a scale of 1-10. In simple terms this means that at the beginning when you have £50 of each the overall portfolio profile is a 5/10.
However after that year when you now hold 7x as much in Fund A as in Fund B the risk profile of the overall portfolio has completely changed. So now in simple terms the portfolio overall is closer to a 2. Therefore much ‘lower risk’ than originally intended and as every investor knows the lower the risk the lower the potential long term returns.
So the two main reasons to rebalance are to;
- Sell ‘em high and buy ‘em cheap’
- Control the risk profile of the overall portfolio
When should you rebalance?
Now that we understand that rebalancing is the smart long term thing to do we are faced with the question of when we should rebalance.
There are essentially two schools of thought on when you should rebalance;
- Strategically
- Periodically
And from my research you can find as many studies that support one method as the other.
Periodic rebalancing is exactly how it sounds, you simply set up your investment/pension portfolio and rebalance at set intervals, daily, weekly, monthly, yearly etc.
The issue with periodic rebalancing is that if you rebalance too often then you are selling assets before they have the opportunity to make any significant gains, but if you rebalance too infrequently then the portfolio risks straying too far from the original risk profile.
Strategic rebalancing on the other hand is making a conscious decision of when is the best time to rebalance and this of course has the risk of human error or failures of judgement. I have often come across DIY investors who have operated this way and the pattern I have seen is that they have tended to carry out their rebalances either in the middle of a market rally or fall. I put this down to a ‘must do something’ mentality that kicks in when ‘things are happening’
My own view is that for strategic rebalancing one always has to have one eye on the shifting risk profile of portfolios while looking for periods of calm in the markets as ideally you want to be rebalancing at the top of market rises and the bottom of market falls.
Strategic vs Periodic Rebalancing – Which approach do I prefer?
I have to say my colours are not nailed to either mast, I am always prepared to reconsider my opinion and I have been doing that again recently.
Since I launched our in-house portfolios in 2017 I have been strategically rebalancing, but recently I carried out some ‘back testing’ research to see what would have happened if I had been periodically rebalancing instead.
So what is ‘back testing’, essentially it’s using hindsight and historical data to see where the portfolios would be today if I had set them to auto-rebalance at various intervals. What I found was that annual was the most effective ‘automatic’ period. However, which month we used for the annual rebalance made a really big difference to the overall performance.
But how did that compare to my ongoing ‘strategic rebalancing’ well to date I would say ‘six of one and half a dozen of the other’ would be a fair description. If we look at different points in the history of the portfolios there are times when annual rebalancing (if we chose the best month) would put the portfolios marginally ahead and just as many times my strategic approach would.
Moving forward I intend to continue with strategic rebalancing as only 1 of the 12 months in a year as the ‘annual rebalance’ was competitive with the performance as my strategic rebalances has been. But then this is my working life, I have more time to think about this than most people so for the DIY investor I would suggest setting and forgetting an automatic rebalance is the best thing to do. If you’re interested in my research April was the best month to rebalance – but there are other more in depth studies than mine with different results!
Unfortunately as much as we might like to think it is, investing is not a ‘pure science’ there are simply too many variables for that for a perfect model to exist.