Rebalancing

Rebalancing is the rebalancing of the weighting of asset classes within a portfolio with the aim of maintaining the desired asset allocation, thereby reducing its volatility (commonly referred to - wrongly - as "risk"). The main objective of rebalancing is to return to the initially chosen investment strategy.

For example, if you wanted to have a portfolio of 60/30 stocks and 40/30 bonds, but due to better stock performance your asset allocation has shifted to 70/30, you might decide to sell some of your stocks and buy more bonds with that money to get back to your original weighting.

The rebalancing strategy differs from that of buy and hold which consists of no longer touching a position once acquired. Rebalancing is also different from market timing: we do not seek to predict future market movements, we simply rebalance the composition of our portfolio which has changed over time based on past market movements.

Rebalancing allows you to sell high and buy low, which intuitively seems like a good thing. Thus, we will buy more shares in a bear market than in a bull market, a countercyclical strategy par excellence that proves profitable in the long term.

Main benefits of rebalancing:

• Reduce the risk of loss from a position becoming too large.
• Smooth out your results.

Main disadvantages of rebalancing:

• Additional transaction fees.
• Risk of limiting the size of its big winners and increasing its exposure to losers (like you would have regularly sold Nestlé to buy Swissair, making your portfolio ultimately much riskier).
• A rebalancing frequency must be chosen (for example, once a year or every quarter), but the choice of this frequency is arbitrary and itself has a significant impact on the results. Another method often used is to rebalance your portfolio each time an asset class deviates, for example, by 5 or 10% from the target value.

It is normal for a bank to periodically rebalance the asset allocation of its clients as part of a wealth management mandate, in order to continue to stick to the strategy initially chosen by them. On the other hand, for the Jeromes and Dividins of this world who prefer to manage their portfolios themselves, the question of the benefits of rebalancing really arises.

Before going further in the reflection and to avoid any misunderstanding, I find it important at this stage to distinguish between two main types of rebalancing:

• Rebalancing between asset classes (stocks, bonds, real estate, raw materials, alternative investments, etc.)
• Rebalancing within an asset class (e.g. selling some of your winning stocks and buying more of those that have lost value).

Rebalancing between asset classes

I am of the opinion that the advantages outweigh the disadvantages when it comes to rebalancing between different asset classes of a portfolio (for example, rebalancing the proportion between stocks and bonds). This mechanical approach makes it possible in particular to limit the impact of our emotions and reduce portfolio volatility.

Given the outperformance of stocks relative to bonds over the long term, an unbalanced portfolio will continually increase its proportion of stocks. Vanguard, for example, calculated (https://vanguardcanada.ca/advisors/articles/research-commentary/portfolio-construction/best-practices-for-portfolio-rebalancing.htm?lang=fr) that a portfolio composed in 1926 of 50% shares international and 40% international bonds would have contained (without rebalancing and reinvesting dividends in stocks and coupons in bonds) 97% shares in 2014! That's a lot, even for a stock fan like me...

In the Vanguard study, the increased stock weighting caused the never-rebalanced portfolio to have a higher average annualized return than the annually rebalanced portfolio (8.9% vs. 8.1% vs. 10.1% vs. 11.1% vs. 12.1% vs. 13.2% vs. 14.1% vs. 15.1% vs. 16.1% vs. 17.1% vs. 18.1% vs. 19.1% vs. 20.1% vs. 21.1% vs. 22.1% vs. 23.1% vs. 24.1% vs. 25.1% vs. 26.1% vs. 27.1% vs. 28.1% vs. 29.1% vs. 30.1% vs. 31.1% vs. 32.1% vs. 33.1% vs. 34.1% vs. 35.1% vs. 36.1% vs. 37.1% vs. 38.1% vs. 39 ...

This study is consistent with the results of most others: Rebalancing across asset classes slightly reduces performance but significantly reduces portfolio volatility. In other words, risk-adjusted returns are improving.

Rebalancing within an asset class

When rebalancing is practiced within the same asset class, I find that it can be counterproductive.

Isn't selling your winning positions (i.e. stocks that have performed well recently) to increase the weighting of your bad apples (stocks that have lagged behind) shooting yourself in the foot? It certainly is against the famous recommendation "cut your losses short and let your winning positions run".

Selective sales, yes. Systematic sales, no! Selling a position just because it has increased in value, no thanks.

If stocks such as Nestlé, Geberit, Givaudan, Mobimo or Schindler double and their fundamentals have not deteriorated, I see no reason to sell them (fully or partially). Just because a stock has doubled does not mean it will not continue to appreciate.

Moreover, lightening a position just because its price has appreciated is letting the market dictate what to do. rather than making decisions for yourself in a thoughtful manner.

On the other hand, I would probably no longer be comfortable if more speculative, cyclical, banking or technological positions were to be overrepresented in my wallet.

Likewise with a quality action which would have become grossly overestimated or if a position takes up too much space in my portfolio (following an exceptional performance, this stock represents for example 15% of the portfolio while at the base no position exceeded 5%). In this case, reducing the weight of this security can make sense for diversification purposes, respectively in order to avoid the concentration of risks.

The final word

Reinvesting your dividends in shares that you did not yet own allows you to mechanically cap the relative weight of your largest positions, without having to sell them.

You could call it a soft version of rebalancing.

That's what I call having your cake and eating it too.