This is the editorial of our monthly Quant Value Investment Newsletter published on 07-05-2024. Sign up here to get it in your inbox on the first Tuesday of every month.
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How to Rebalance Your Portfolio
A subscriber recently sent me a good question on how to rebalance his portfolio and I thought it is something that may also interest you.
Here is his question:
I have a question about rebalancing – when you rebalance/rotate positions out and in how do you deal with sizing? Assume I have a portfolio of 20 positions of 5% each initially, when I rotate a position out and buy another one, the position I rotate out will most probably be less than 5% (or maybe more if it performed strongly earlier).
If I now have a new entry, I could just use the proceeds from the earlier sale, but that would lead to the new position being underweighted (overweighted) from the start.
Alternatively, I could sell some shares of my strongest performers to top-up the new entry, but cutting my best stocks might not be a great idea if they still have good momentum.
Lastly, I could rebalance the entire portfolio, but that involves a lot of trades, trading cost and cutting some of my stronger stocks.
As you can see, he raises a good point, and it is something we all must deal with when buying and selling.
Portfolio rebalancing is the adjusting the weights of different investments as values change over time. The weights of investments are also known as position sizes.
Understanding Position Sizing in Portfolio Rebalancing
Position sizing is crucial as it decides the weight of each investment in your portfolio, affecting both risk and potential returns.
If an investment's value changes significantly, its part in your portfolio will also change, which may not align with your strategy.
The newsletter recommends fixed 2% buy positions which gives you a very diversified portfolio where the strategy, not the individual positions, is the most important factor.
You can of course decide on your own weights however we recommend that you keep them under 5% to give you the benefit of diversification.
Challenges in Rebalancing
As the question mentions, when you sell an investment, the proceeds may not match the intended size for a new purchase, leading to an imbalance. This could result in the new investment being too large or too small, potentially disrupting your portfolio's balance from the outset.
Strategies for Effective Rebalancing
You can choose to rebalance your entire portfolio to realign every investment with your original size, but this may not make sense as it increases transaction costs.
A better idea is adjusting only the most misaligned positions. This reduces costs and keeps your portfolio in line with your goals.
For example, if you sold an investment for a loss, leaving you with a smaller position to reinvest you could add cash to your portfolio or sell some of your largest gain to make up for the difference and give you a full position size again.
Yes, this option does reduce the investment of the company with the best momentum (biggest gain) but remember you want the investment strategy to drive your gains not the largest position.
Also, it is not that large positions get sold all the time, only now and then when you need a bit of cash to top up an investment sold at a loss.
If you sold a position with a large gain your next investments will be a bit larger as your portfolio has grown. If there is still cash left over hold it in a money market fund until it can be used with a next investment.
Conclusion
Regularly review your portfolio to check for imbalances that may need rebalancing is essential maintenance for your portfolio to make sure it still is diversified.
Also, as with anything in investing, there is no “right” answer there is only “what works for you”.
Your analyst wishing you profitable investing
