Why Rebalancing Your Portfolio Is Important

Matt Thalman - INO.com Contributor - ETFs - Rebalancing

Despite only being three months into 2018, investors have been on quite a wild ride. The market started off the year as it ended 2017, on a tear higher, then the brief crash in early February, which led to a nice calm recovery during the remainder of the month just to run into what I’m calling “Whipsaw March” with the market jumping higher and lower by more than 1% nearly every other day. Not only have the major indexes been extremely volatile, but some of 2017’s biggest winners, big technology and especially the FANG stocks have seen their prices fall more than 10% in 2018.

Big pops that reverse fortune and the big drops that follow always cause investors to wonder what they could have done to protect themselves from the decline without completely abandoning their position.

The most straightforward and most effective answer to that situation is to rebalance your portfolio. Rebalancing is when you bring the percentage of your holdings back in line with each other.

For example, if you have a portfolio made up of 10 stocks and each represents roughly 10% of your portfolio, you would have a ‘balanced portfolio.’ Now if one of your stocks outperformed the others and ended up representing say 25% of your portfolio, instead of just 10%, then you would rebalance by selling some of your shares in that company until it represented 10% of your total portfolio.

This rebalancing protects you from what we just saw happen, a stock like Netflix Inc. (NASDAQ:NFLX) jumps 100% and then falls 10% in a matter of days. The rebalancing will lock in some of your gains and reduce the overall effect of that 10% decline on your whole portfolio.

One might wonder if this method of selling your winners really works, well some studies show that a rebalanced portfolio will outperform a non-rebalanced portfolio over the long run, so it may be something to consider doing if you don’t already.

The rebalancing example shown above can be done regardless of whether you own individual stocks, exchange-traded funds, mutual funds, or any investment for that matter.

But remember if you own ETF’s, more times than not, the fund itself will rebalance at some point throughout the year. Sometimes the fund will rebalance on a set schedule while others perform the rebalance as the fund grows out of balance or just because the fund manager believes that is the best move.

The determining factor to whether or not the ETF does this rebalancing on a set schedule or just whenever, is whether or not the fund is actively managed or passively managed. A passively managed fund are those that track indexes, such as the SPDR S&P 500 ETF (PACF:SPY), which follows the S&P 500. These types of funds will rebalance only when new components are added to the index or at regularly scheduled times, (say at the end of the year, semi-annually, quarterly, etc.). Actively managed funds rebalance when the fund manager decides its time to rebalance. It’s usually because the fund is no longer balanced, but it can simply happen because the manager wants to exit a position altogether or any other countless number of reasons.

So while you need to pay attention to your own portfolio weighting, you also need to watch how the funds you own weight different stocks and make sure you're not overly exposed to any one company, or you may want to rebalance the funds you own. A perfect example of this would be Apple Inc. (NASDAQ:AAPL) which is likely the largest holding in any S&P 500 indexed fund since Apple is the largest publicly traded company. Say you own the ETF SPY, Apple’s weighting in that fund is 3.79%, not too bad. But say you also own shares of the technology ETF iShares U.S. Technology ETF (PACF:IYW), Apple represents 16.55% of that fund. Maybe you own a little of the iShares Morningstar Large-Cap ETF (PACF:JKD), well Apple represents 11.19% of that ETF.

My point is, if you are heavily invested in funds, know what the funds own and how much exposure you have to some of those funds top holdings, or you could be massively overweight one or more companies and not even realize it.

Rebalancing may not be something all investors want to do because it will increase transaction costs and tax liabilities at the end of the year. But, it is a simple, easy way to reduce some unwanted and often unthought about risk.

Matt Thalman
INO.com Contributor - ETFs
Follow me on Twitter @mthalman5513

Disclosure: This contributor held long positions in Apple and Netflix at the time this blog post was published. This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.