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Year-end is always a
time of reflection, a rare opportunity where the usual psychological
boundaries of time crumble. For a couple weeks, the tyranny of the present
yields to a heightened consideration of the past and the future. This rift in
our everyday thought patterns leads many investors to ponder the composition
of their portfolios, making this time of year the primary season for
portfolio rebalancing.
While the concept of
portfolio rebalancing is simple, many investors struggle with the practical
execution. The whole idea of investment is deploying the surplus fruits of
our labors in productive assets that can earn returns for us. We all work and
use the resulting earnings to finance our lifestyles. And if we prudently
live within our means, we are blessed with leftover capital after all
expenses. Rather than let it sit idle, we invest it.
But it is foolish to
invest all this hard-earned surplus capital in one place. Diversification is
absolutely critical for investment, it radically lowers the risk of
catastrophic losses. This principle is nothing new, some thirty centuries ago
the ancient Israeli King Solomon wrote, "Cast your bread upon the
waters, for you will find it after many days. Give a portion to seven, or
even to eight, for you know not what disaster may happen on earth." (Ecclesiastes
11:1-2)
Portfolio rebalancing
is the ongoing discipline of ensuring the whole pie of your investment
capital is sliced up optimally to maximize returns and minimize risk. It is
the actual mechanics of diversification. How should an ideal version of my
portfolio look? How do I evaluate the fundamentals of my existing
investments? How do I decide which investments to keep, sell, or buy? And
when are the best times to make these portfolio adjustments?
Since I hear these
questions year after year, this essay lays down some crucial foundational
principles inherent in portfolio rebalancing. While it’s impossible for
any discussion to address all questions, I hope this one proves useful as a
strategic framework in which to structure your own portfolio rebalancing.
Maintaining an Ideal
Portfolio Balance. Diversification effectively spreads risk because it
ensures all your eggs are not in one basket. If severe misfortune falls upon
a company you own and ravages its stock price, the damage is contained
because it is just one of many stocks you own. If you don’t diversify,
sooner or later the odds will catch up with you and you will suffer a
catastrophic loss. Even elite investment-grade companies are far from
bulletproof, bad surprises happen.
If you have all your
capital in one company, and its stock craters by 50%, half of your
investments are wiped out. This is nearly impossible to recover from in a
reasonable period of time (a few years). But the more diversified you are,
the less these specific-company risks matter. If you have 2 positions, and
one falls by 50%, you take a 25% overall loss. But if you have 10, and one is
cut in half, your total investment-portfolio loss is just 5%. Diversification
minimizes risk.
At a bare minimum, I
believe investment capital should be divided 10 ways. In the stock markets
this is easy and practical even with very small investment portfolios (say
$10k). And if you have significant investment assets (say $100k+), 20 ways is
even better. Personally my own investment-capital target is always 20
positions. Depending on buying and selling opportunities, sometimes I have
more than 20 and sometimes less, but they fluctuate around this long-term
goal.
Ideally, the capital
allocated in each of your positions should be equal. If you have 10 or 20
investments, but half your capital is still in just one of these, your
diversification is merely an illusion that offers little protection. Spreading
your capital out roughly evenly is essential for managing risk and ensuring
that no one company can materially damage or derail your investments’
gradual accumulation of wealth for you.
Having equal
allocations is easy if you are building a brand-new portfolio. You simply
take your investable cash, divide by X positions to find your allocation,
decide which companies you want to invest in, calculate how many shares you
can buy in each company with your allocation, and make the buys. But once you
are deployed, your positions all move independently and the equality of your
capital spread diverges. The longer you hold your portfolio, the greater this
disparity grows.
In general, the
returns across positions within any portfolio form the classic bell-curve
shape. The majority in the middle see similar returns, and preserve rough
equality in their allocations. But the outliers really throw things off.
Almost any portfolio you construct will usually have a couple of big losers
and big winners, the tails of the bell curve. If you start out with 5%
allocations (20 positions), and your worst performer loses 50% while your
best performer doubles, you’ll have 2.5% of your capital in the former
stock and 10% in the latter.
Portfolio rebalancing
is designed to address these naturally-shifting allocations. In its simplest
sense, it merely involves re-allocating the capital among your existing
positions so they are brought back near equality. Mechanically this is easy.
You take your entire portfolio size and divide it by the number of positions,
which gives you your new allocation target. As your portfolio grows in value,
so will your equal fractional allocation so you have to recalculate it at
each rebalancing.
With your target
allocation in hand, you simply sell enough shares of each winner (which will
be larger than the equal allocation) to whittle these positions back down to
your target percentage. The cash raised from these sales is then immediately
used to buy enough shares in your losers (which will be smaller) to bring
them up to target. With 20 investment positions managed in online trading
accounts, this is easily accomplished in an hour. At most it is 20 trades,
and usually less since the average positions in the middle of the bell-curve
distribution are often close enough to equal that they don’t need
adjustment.
This simple
rebalancing is essential, I highly recommend it. Not only does it keep your
diversification working to minimize risk, but it subtly maximizes returns. How?
Over time, in an investment portfolio of fundamentally-sound stocks some will
always be underperforming while others are outperforming. And for any
individual stock, there is an endless oscillating cycle between periods of
poor performance and great performance.
So after one of your
weaker stocks underperforms, odds are it is due to soon see
better-than-average performance. And after one of your stronger stocks
outperforms, it is likely due for a breather and will see worse-than-average
performance. Simple rebalancing effectively takes partial profits in the
winners, which aren’t likely to continue surging at their recent pace,
and redeploys them in the losers, which are due to surge next. Rebalancing to
maintain roughly-equal allocations harnesses this dynamic in your favor,
greatly enhancing your ultimate long-term returns.
And you can also
rebalance on an ongoing basis instead of all at once, especially if you
continue to add new capital to your investment portfolio from time to time. As
you make a new contribution from your monthly or quarterly surplus income,
use this new cash to buy more shares in your positions that happen to be
underallocated at the time. If you have 20 positions and a 5% target
allocation, deploy new capital only in positions under 5%. This dynamic
rebalancing can often eliminate the need for an annual one (and for selling
any shares at all).
Many investors want
to or need to go beyond simple rebalancings which merely rejigger individual
allocations but keep the same investments. They look at their portfolio and
are no longer as confident in their mix of investments as they were
initially. They believe some of their existing investments are no longer
optimal and/or have learned about other companies that may make better
investments. When selling or buying entire investment positions, far more
must be considered in the rebalancing.
Fundamentally-Driven
Position Evaluations. By definition, investment is a long-term pursuit
measured in years. Investors are looking for outstanding companies that have
such bullish fundamentals that they should thrive and grow for a long time to
come. This means they are successfully producing products that are in demand
now and likely to stay in demand, and that these products are sold for
healthy profit margins. If a company is not consistently selling products for
solid profits, it is a speculation.
Considering each
position’s core supply-and-demand fundamentals and likely future
profitability is essential in any advanced rebalancing. A prudent investor
won’t base decisions to change his portfolio on emotions, but on hard
fundamental analysis. Every decision made to sell an existing investment or
buy a new one should be fundamentally-justified. And every decision must
advance the greater goal of building a stronger overall portfolio by
maximizing potential returns while minimizing potential risk.
Over the long term,
any stock price eventually follows its underlying company’s profits. So
investors want to divide their capital up among elite companies that have
proven they can profitably operate their businesses and have great prospects
for growing in the future. Investors need to consider each company’s
product mix, how fast demand for these products is likely to grow globally,
and how that company is likely to fare relative to its competitors.
If you already have
your full complement of positions, and you want to add a new one, sell the
existing position that looks the weakest fundamentally. And make sure that
the new company has superior fundamentals to the one you are replacing. While
evaluating fundamentals sounds challenging, you can usually make sound
high-level fundamental judgments that don’t require countless hours of
deep research.
For example, back in
early 2006 we made an investment in the world leader in coal-to-liquids and
gas-to-liquids technologies. These processes take the cheap and abundant
resources of coal and natural gas and convert them into synthetic oil that
can then be refined into gasoline and diesel to fuel conventional cars and
trucks. It is really neat technology that will certainly be important for our
world’s future at some point. But probably not in the next few years.
While today’s
focus is still on reducing oil demand, governments have shifted to pushing
electric cars rather than converting other fuels to oil. Instead of burning
gasoline or diesel in individual cars, coal, natural gas, and uranium are
burned in power plants and the resulting electricity is shipped over the
existing grid to charge batteries in electric cars. This is a major paradigm
shift away from CTL/GTL technologies that significantly degraded the
fundamentals of the companies advancing them. So we recently exited that
particular investment.
If you become aware
that the market for one of your investment’s key products is
deteriorating, being replaced by something else entirely or losing share to a
competitor’s superior offering, then it is time to consider pulling the
plug on a fundamental basis. You don’t want investment capital tied up
in companies with shrinking market share and profits. Their stock prices are
simply not going to thrive over the long term.
Making these
fundamental judgments is much easier if you stay abreast of your investments.
You own them, so you are probably interested in what these companies are
doing. While the truly hardcore read quarterly and annual reports and devote
considerable time and effort, more casual investors can still learn much in a
fraction of the time. If you spend a few hours a month reading news on your
investments, which is easy to find with Google, over time you’ll
develop a solid understanding of how they are doing fundamentally.
For the more
motivated, comparative analysis also offers many fundamental insights. You
can go to financial websites and compare your position’s key metrics
with its competitors’. Does your stock have a higher or lower
price-to-earnings ratio than its peers? Is it larger or smaller in
market-capitalization terms? Are its dividends higher or lower? While beyond
the scope of this essay to explain how to use metrics like these, taking a
little time to learn about and compare them offers a great deal of
fundamental insight.
You can also buy
outstanding fundamental-analysis work from professionals. At Zeal for
example, we undertake large research projects looking at all of the
publicly-traded stocks in a given sector. Then we painstakingly whittle this
universe down to our favorites. After that we summarize our exhaustive
research on these elite stocks in fascinating fundamental profiles compiled
into comprehensive reports. For just $95, you can learn a great deal about a
dozen fundamentally-impressive stocks and reap the benefits of hundreds of
hours of professional research. We just published our latest report this week
on our favorite Junior Base Metals Stocks (although these are speculations,
not investments).
Sector-Diversification
Considerations. Even after you’ve identified a fundamentally-superior
investment to replace one of your existing ones, you have to carefully
consider how the new company will fit into your overall portfolio. Even if
you own 20 stocks, but they are all in the same business, you bear heavy
concentrated risk since all stocks tend to mirror their sector’s
action. Prudent investors spread their investments across different sectors.
So consider how many
investments you already own in the sector of the stock you wish to add. If
half of your investment capital is in one type of stocks, you probably
don’t need to put an additional allocation in this same sector. Instead
if you really want to buy a new stock in that same sector, replace one of
your existing positions in that sector instead of increasing your overall
sector exposure.
Consider this
example. Imagine you have a commodities-stock portfolio with 20 positions. 7
are in gold stocks, 3 in silver stocks, 3 in base-metals stocks, 3 in oil
stocks, 2 in natural-gas stocks, 1 in a uranium stock, and 1 in a potash
stock. If you sell anything but a gold producer for any reason, and want to
redeploy the capital, it doesn’t make sense at the portfolio level to
buy another gold stock. With its existing heavy gold-stock exposure, your
portfolio already has a plenty-aggressive gold-stock weighting. Make sure you
stay relatively diversified between sectors, as sector-specific selloffs can
really hurt if you are not.
Fine Tuning
Rebalancing Timing. If you just want to rebalance once a year and be done
with it, you can certainly do all your adjustments at one time. You can sell
any old positions that are no longer fundamentally attractive enough for you,
buy new positions, and rebalance capital allocations among existing positions
in one fell swoop. But if you watch the markets regularly, you can fine tune
these actions which really boosts overall returns.
If you want to sell
an existing position, try to wait until it has risen significantly and is overbought.
The goal of investing is to buy low and sell high, and portfolio rebalancings
don’t need to be an exception to this rule. When the position you want
to sell has rallied far, or seen fast gains, seize the moment to sell it even
if there is nothing else you are ready to buy right then. You can hold cash
until you find a good deal in a replacement investment.
Similarly if you want
to buy a new position, watch the company’s stock for awhile and try to
add it when it is oversold. This means it has fallen significantly, looks
weak, and is temporarily out of favor in the markets. The lower you are able
to buy any investment, the greater its ultimate returns will be. Since almost
all stocks follow the general stock markets, most investment-grade companies
all tend to be relatively low or relatively high at the same time. So the
complete rebalancing trade is spread across time.
Here’s a
real-world example. In our Zeal Intelligence monthly newsletter, for many
years we’ve maintained a model investment portfolio for our subscribers
to emulate. In 2008 we had 20 positions, right on target. Then that
year’s once-in-a-lifetime stock panic hit, and every stock in the
markets plunged precipitously. The resulting fire-sale prices presented the
buying opportunity of a lifetime, so we added 4 new investments in the heart
of the panic. But this took our total positions to 24, too high.
But it didn’t
make any sense selling when everything was so beaten down. So we waited for
the better part of a year until stocks had recovered massively from their
panic lows before we started selling old positions that the new ones were
intended to replace. Today, a year after that big 4 position buy, we have 22
investment positions but continue to gradually whittle them back down to 20 as
market conditions allow. This month we sold that CTL/GTL company I discussed
earlier near $40 a share, a much-better price than the $29 it was trading at
during the stock panic when we added those new positions.
How can you tell if a
particular stock is overbought or oversold? One quick way is to consider
where its price is relative to its 200-day moving average. In bull markets,
stocks are usually near or under their 200dmas when they are oversold and
cheap. And they are always stretched far above their 200dmas when they are
overbought and expensive. A recent essay explains this trading theory in
depth.
If you buy
investments when they (and their sector and the general stock markets) are
near their 200dmas, you’ll get some of the best (lowest) entry prices
seen in an ongoing bull. And if you sell investments when they are way above
their 200dmas, you’ll reap some of the best (highest) exit prices. Timing
is critical for buying low and selling high.
While it certainly
complicates portfolio rebalancing to try and time buying and selling when
adding, jettisoning, or replacing an investment, it can greatly enhance your
long-term returns. And if you are an active investor who speculates on the
side with a separate portfolio of risk capital, you are already putting in
the effort necessary to time the sectors you are interested in. You may as
well apply this hard-won knowledge to your investment rebalancings too.
Portfolio rebalancing
is essential for all investors. Even through the simplest annual rebalancing,
investors can substantially increase their long-term returns while
simultaneously minimizing risk. Keeping position allocations roughly equal as
the years pass helps harness some powerful market forces and principles in
your favor. And if you graduate to some of the more advanced rebalancing
tactics, you can achieve far greater boosts in your ultimate gains. Don’t forgo the benefits
of rebalancing!
Adam Hamilton, CPA
Zealllc.com
December 26, 2009
Also
by Adam Hamilton
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Intelligence, that details exactly what we
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and really appreciate your feedback!
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