Thoughts from Reddit: Rebalance portfolio or just roll with it?

In this edition of ‘Stock Teasers’ we are going to be looking at a submission to /r/CanadianInvestor on Reddit, the user is asking if investors should rebalance the portfolio. Let’s dive in!

As a long-term investor, maintaining a well-balanced portfolio while keeping in mind the idea of letting the winners run is not only an art but also a critical component of successful investing. We’ll discuss why the two should be considered and balanced carefully:

• Letting the winners run: investors should feel comfortable with the idea of letting the winners run, which means a few positions may account for a major chunk of the portfolio given that these positions are a result of a cumulative gain over the years, not the initial allocation. It is because over a lifetime of investing, returns would not come evenly from all the holdings in the portfolio. In fact, the investment community usually refers to the Power Law, which dictates the investment outcome in investing. The Power Law means that over the long term, a few winners will carry the majority of the returns for the portfolio, while the rest will either break even or underperform. Investors who do not appreciate this will often make the common mistakes, including selling the winners too early or “cutting the flowers and watering the weeds”.
• Portfolio rebalancing: The key objective of rebalancing is to manage risk, not maximize returns. Most investors build a foundation for a portfolio with a targeted allocation to different exposures and themes. However, market value fluctuations lead to deviations from the initial intended targets. This makes occasional rebalancing especially critical, as it helps reduce the volatility of the overall portfolio. Typically, there are two methods of rebalancing consisting of 1) calendar-based rebalancing: investors set a time in their calendar (quarterly, semi-annual, etc.) and rebalance accordingly. Investors need to be disciplined on the timing of this. 2) Threshold rebalancing: investors set a target range of weightings that they are comfortable with and rebalance when a holding moves widely outside of the range. For instance, investors might be comfortable with a particular ETF at a 10% weight and would allow the position to run as high as a 15% weight at most. Whenever the fund exceeds 15%, the investor would rebalance back to 10%.  Conversely, when the allocation drops below five percent, investors would need to add to the position to bring it back to 10%.

We think investors who rebalance the portfolio too frequently could be at the risk of “cutting the flower and watering the weeds.”, while at the same time increasing expenses in terms of taxes and trading fees. We think for most active investors, rebalancing based on certain thresholds makes sense.

 “Letting the winners run” and portfolio rebalancing should be considered simultaneously in the decision making process in order to optimize returns while managing risks prudently. That being said, at the end of the day, portfolio allocation is a personal decision, how concentrated investors allow a position to become depends largely on his/her temperament and the ability to sleep well at night.

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Authors, directors, partners and/or officers of 5i Research do not hold a financial or other interest in the above companies at the time of publishing. The i2i Fund does not hold financial or other interest in the above companies or ETFs at the time of publishing