A Rebalancing Strategy for All Seasons

In Tuesday's huge bounce, most of the market segments that had been crushed were leaders to the upside.

Contributing to the gain was the overselling in sectors such as commodities, foreign currencies, mining stocks, foreign stocks and energy stocks. No shock there. If the jump turns into a bear market rally (or as I like to call them, "feel-good rallies") that lasts for a month or two, the increase in these segments could be massive.

Many people, as often happens during big declines, probably learned that they had too much exposure to all of these segments. They worked great for years on the upside. Maybe as a function of not rebalancing or something else, the declines really hurt people. If you are wearing these shoes and had some real worry, it probably makes sense to lay out a plan to reduce exposure if there is a prolonged rally.

None of these asset classes are permanently broken, but real stock-price recovery could take a long time. Regardless of how long that takes, they will have scary declines in the future.

I am all for having exposure to the market segments mentioned above, but just as having no exposure is a big bet, so too is having too much exposure. All sorts of academic papers make a compelling case for holding 15% to 20% in commodities. I can't out-debate volumes of academic research, but 20% seems crazy to me. Plenty of people make the case for a large portion in emerging markets, on the basis of that segment's share of global GDP. Again, it is valid but more than I want.

Equities are not permanently broken. If you agree, then you don't need too much in commodities. If you have any interest in smoothing out your ride, you don't want 20% in emerging market either. An investor could have easily put 5% into iShares MSCI Emerging Market ETF ( EEM) early in 2003 and then sold half of it every time it doubled. In this example, there would have been a sale in late 2004 and again in mid-2007. This sort of a path would have certainly added to the portfolio result: 10 percentage points to the overall result, with just 5% of the original portfolio in an era where the stock market is about flat, and with less volatility.

There would have been a similar result with mining stocks too. We can use BHP Billiton ( BHP) as a proxy going back to 2003, as there is no mining ETF, at least not that I am aware of. A 5% weight in BHP in early 2003 cut in half after every doubling in price would have resulted in sales during October 2004, April 2006 and May 2008, adding 15 percentage points to the overall result for five years, again in a five-year period when U.S. equities were flat.

The two combined could have added 25% in returns to the overall portfolio from just 10% of the portfolio and using a reasonable rebalancing plan. This would have also left much less exposed to the ride down in 2008; both EEM and BHP are down over 50% year to date.

In trying to make this point, EEM and BHP are hardly obscure names. Picking a broad-based ETF and a best-of-breed name from a sector is far from a stretch. Anyone picking the exposure five years ago made good choices, but that was not the end of the work needed.

Jim Cramer likes to warn that in the investing world, pigs get slaughtered. I don't know if giving back that much in gains by choosing to not rebalance is considered a slaughtering, but not doing so can prove unnecessarily painful. As simple as this seems, not enough people rebalance.

At the time of publication, Nusbaum had no investments in the securities mentioned in this story, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

More from ETFs

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

60 Seconds: What's the Difference Between an ETF and a Mutual Fund?

Video: Why Shark Tank Star Kevin O'Leary Is Doubling Down on Internet Stocks

Video: Why Shark Tank Star Kevin O'Leary Is Doubling Down on Internet Stocks

Simple Investing Strategies Stand the Test of Time

Simple Investing Strategies Stand the Test of Time

This Technology ETF Could Be Signaling a Looming Tech Stock Rout

This Technology ETF Could Be Signaling a Looming Tech Stock Rout

The End of Retailpocolypse? This Retail ETF Is Soaring

The End of Retailpocolypse? This Retail ETF Is Soaring