Rebalance to Boost Gains and Lower Volatility

This week you may notice more volatility and volume than normal in many of your favorite companies. That’s because four times a year the S&P Dow Jones Indices will readjust the representation of the ~500 companies that make up the benchmark.

This happens to be the week of that quarterly rebalancing. When the market opened on June 24— and based on market levels as of last Friday — the S&P 500 made adjustments in its constituent holdings. All exchange traded funds (ETFs) and mutual funds that track the S&P 500 will have to adjust holdings based on the rebalance, which means a lot of buying and selling this week.

The end of this week will mark the end of the first half of 2019, and just as the S&P 500 is rebalancing, it may be time to revisit your own portfolio’s allocations.

Portfolio Checkup

If you have a particular portfolio allocation target — as many of us do — that allocation will become skewed over time. As an example of how rebalancing is done, let’s assume you have a portfolio in which you try to maintain a specific balance of different sectors. Let’s assume that for an aggressive portion of your portfolio you want to have 50% of your funds in Information Technology, and 50% in Healthcare, and that was your allocation at the beginning of the year.

Here at midyear, all sectors are up for the year. But let’s consider how the relative sector performance would have impacted your overall sector allocation.

At midyear, $100 in Information Technology has grown to $127.37. Healthcare has lagged this year, so $100 in Healthcare has only grown to $109.33. You now have $236.70 for every $200 you had invested at the beginning of the year. But Information Technology now makes up ($127.37/$236.70) = 53.8% of your portfolio. Healthcare’s share has declined to 46.2%.

In order to rebalance to a 50/50 allocation, you want $118.35 in each (half of $236.70). So you sell $9.02 of your Information Technology and put that back into Healthcare, recapturing the 50/50 balance.

The Impact of Rebalancing

In 2015, Morgan Stanley (NYSE: MS) published an article demonstrating the impact of annually rebalancing a mixed portfolio of stocks and bonds. In every case, rebalancing enhanced returns of a mixed portfolio:

The article also demonstrated that rebalancing lowers the volatility of this portfolio, and elaborated on why annual rebalancing improves performance:

How can this modest amount of rebalancing create such significant value? Rebalancing takes advantage of the long-term effects of mean reversion. By lightening up on stocks after periods of significant outperformance, or topping off positions after periods of underperformance, this discipline helps take advantage of volatility to benefit from these swings.

Rebalancing doesn’t require any particular insights into which sectors will perform well, it just requires a consistent and disciplined approach. The beauty of rebalancing is that it forces you to have discipline. You will take some profits in your winners and shift that money into your underperformers. Since these sectors are cyclical, periodic rebalancing can lower the overall risk and enhance your returns over time.

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