Common Questions Regarding Portfolio Rebalancing Answered
Most investors plan their stock portfolio in a way that they buy the same amount of each stock. However, as each share performs unequally, it is common to see an unbalanced portfolio over time. Many investors prescribe the strategy of rebalancing their portfolio so that it is equally weighted across all their holdings. However, is this really worth the effort? In this article, I will tackle some of the common questions regarding this strategy.
Why should I rebalance my portfolio?
Rebalancing your portfolio is a strategy that investors use to reduce the risk of their investments. If a portfolio is severely overweight on a single stock, any price change in just that stock can have a large effect on your portfolio.
For simplicity’s sake, we take a simple example of a portfolio with just three stocks. At the start of the journey, each stock accounts for 33% of the portfolio. One stock, however, outperforms the other two and has returned 200% in one year. The other two stocks remains stagnant. Your portfolio now consists of one stock accounting for 60% of your portfolio, while the other two only consists of just 20%. Any sudden price movements in the biggest holding will inevitably cause massive changes in your portfolio returns.
In this case, investors need to sell some of the high-performing stock and buy more of the other two stocks to rebalance the portfolio to its original weight. This will then nullify the effects. Naturally, this case is pretty straightforward. Such a severely overweight stock in your portfolio poses a significant risk to your overall returns should it tank.
When is rebalancing not needed?
On the flip side, rebalancing your portfolio too often may be counter-productive. This is especially so when your portfolio is already sufficiently diversified such that each stock holding only consists of less than 10% of your entire portfolio. Even a 200% increase in any stock will not cause the stock to make up too big a portion of your portfolio. In such cases, rebalancing may not be needed due to the time and effort it takes.
Rebalancing can also be a costly affair. Transaction fees can add up if you are constantly shifting money in and out of stocks. Therefore, if the inequality of weight of each stock on your portfolio is not extreme, the cost of rebalancing may not warrant it.
Is it ok to have a slightly larger holding on a high-conviction stock?
Many times, the stock that has appreciated in value ends up being the stock that we are most confident about. The stock price should have appreciated because the underlying company performed well, and the company has room to grow further.
In this situation, it makes sense to hold a larger percentage of your portfolio in this high-conviction stock as it is more likely to continue outperforming the rest of your portfolio. By maintaining a larger holding, you can reap larger rewards when this stock increases.
The Foolish bottom line
At the end of the day, knowing when to rebalance your portfolio takes experience and practice. Before you make any decisions, it is important to factor in the cost of rebalancing, how severely unbalanced your portfolio is and whether you are confident enough to hold a larger percentage of a high-conviction stock.