Why smart money re-balanced

Mean reversion in stock prices/ returns suggests that investors should with discipline rebalance their stock portfolios regularly, and at least once a year. This will improve portfolio risk-return in the long-run as you automatically will buy more shares in under-performing stocks and sell shares in stocks that have outperformed. Rebalancing have been given a lot of academic support and is a well known alpha creating technique among practitioners.

Charles Rotbult published a study in the "American Association of Individual Investors" where he tracked how different investor behavior would effect portfolio returns. The first portfolio was re-balanced when allocations were off target by 5 %, the next portfolio was not re-balanced at all, and the third portfolio reflected an investor who panicked and sold every time the stock index fell by at least 20 % (which a lot of people do).

Not surprisingly the re-balanced portfolio outperformed both on risk and return. Furthermore the panic seller significantly under-performed by all measures. In other words, when everyone is running out the door, you should sneak in. According to the most stringent "the markets are perfectly efficient" theorists out there this should not be possible, however it is. Both stocks and assets classes are mean reverting in their behavior. This may very well be due to the irrational behavior by all those investors buying stocks/ asset classes that are up and selling stocks/ assets classes that are down.

How I re-balance:

My public portfolio is currently invested in three themes, 1) oil stocks, 2) emerging markets, 3) cheap European automobile stocks. By late the theme weights have moved far away from the initial weights as theme one has developed adversely, theme two has done nothing and theme three has outperformed. For the most part I invest an equal amount in each stock I buy (I overweight some stocks, however for the most part i weight all stocks equally).

In order to re-balance I make sure to buy and sell stocks until the above mentioned themes are weighted equally to their original weights, I also make sure that each stock once again has equal portfolio weighting. By re-balancing next week I will be able to take profit in VW and BMW, and at the same time pick up stocks in oil companies such as Statoil and Prosafe on the cheap.    

So how often should you re-balance? It depends on how volatile the components of your portfolio are, and how correlated those components are. I like the idea of re-balancing every time my theme targets are off by 5 % in aggregate.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving any compensation for it.