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Portfolio Rebalancing 101

Adam Hamilton

Dec 26, 2009

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.

The Bottom Line. At Zeal we are speculators and hardcore students of the markets who also maintain separate investment portfolios. Our endless studies of the broader financial markets and individual stocks that are necessary to fuel our ongoing trading are extremely beneficial for investing as well.

For just $10 a month, you can subscribe to our acclaimed monthly newsletter and reap the fruits of our hard labors. In Zeal Intelligence I constantly analyze buy-and-sell timing and general market conditions. I also write about specific investment opportunities from time to time as they arise, as well as maintaining our model commodities-stocks investment portfolio. Subscribe today and become an informed investor!

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

December 26, 2009

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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