Way back in about 1992 I bought 2000 Commonwealth Bank shares at $5.30 (cost $10,700 including brokerage) and since then I have reinvested the dividends, so I now have over 4000 worth $49 (say, $200,000). If I had rebalanced my portfolio by selling most of them I would have missed out on much of this 18,500% gain (or roughly 20% compounded). Not only that, I would have paid a heap of capital gains tax. So why do we hear stories about rebalancing portfolios at this time every year? Surely the wise thing to do is to try always to be aware of the quality of the assets and the management of a company and to sell (or buy) on that basis alone. And long-term performance is about as reliable a guide as any. As the old Mortein slogan went: "When you're on a good thing, stick to it."
Spot on, David! Anyone who sells a great stock like CBA and pays capital gains tax and brokerage in the name of portfolio rebalancing needs their head rebalanced, in my view. Yet there is a lot of it about, largely promoted by those who get commissions from persuading you to trade, and it often happens in January after investors get their year-end statements. The idea of rebalancing is based on fixed asset allocation and modern portfolio theory (MPT), which is sort of the opposite of stock picking. A lot of very intelligent people, including Nobel Prize winners, have focused their lives on asset allocation and MPT, so one ridicules this with care. Not that I’m going to ridicule asset allocation and MPT, but at Eureka Report the investment approach we support is in line with David Moore’s note to us; that is, “Try always to be aware of the quality of the assets and the management of a company and to sell (or buy) on that basis alone”. Modern portfolio theory equates risk with volatility and attempts to achieve the highest possible investment return with the lowest risk or, rather, volatility. For a start, risk and volatility are not the same thing: the greatest risk is that of losing your money; for the long-term investor, volatility is less of an issue. Volatility is a genuine risk for those in the business of investment management because they are assessed by their clients (super funds) on a short-term (monthly and quarterly) basis, and therefore cannot stray too far from the mean. Volatility is measured by “standard deviation”, which is the percentage by which an asset’s price deviates from the mean. Modern portfolio theory, as devised by Nobel laureates Harry Markowitz and Bill Sharpe, attempts to build an investment portfolio based on the “efficient frontier”, the line on a graph showing highest investment return for the optimal level of volatility (see graph below).  The theory is that for any given standard deviation you would choose a portfolio with the highest possible investment return, so anyone would always want a portfolio that lines up along the efficient frontier. Apart from that, the thing to note about the efficient frontier is that it’s not a straight line; it’s curved. That, according to its proponents, is an expression of the benefits of diversification. That is, a diversified portfolio achieves a higher rate of return with a lower standard deviation than just one investment (the straight line), thus producing the bulge to the left in the graph. That’s the theory, anyway. If you are running your portfolio on strict asset allocation lines, whether you are consciously applying modern portfolio theory or not, then you must rebalance your portfolio at least once a year or adjust your asset allocation. That might sound obvious, and against what Eureka Report stands for, but we also reckon that discipline is the most important investment tool you have: whatever approach you use, stick to it. The non-modern theory What approach is best? Well, subscribers of Eureka Report know that we look more to Warren Buffett for guidance than Markowitz and Sharpe. His decidedly non-modern portfolio theory is to buy stocks as if you are buying the whole business, don’t buy many and never sell. We go along with everything he says except the “never sell” line (which Buffett doesn’t really follow anyway). We prefer “almost never sell,” and certainly don’t sell a good stock simply because it has gone up lot and you want to rebalance your portfolio. That’s because we don’t think fixed asset allocations and portfolio theory is the way to go. Why on earth, for example, would I put 10% of my money into cash or bonds at the moment when I have a 10-year investment horizon and there is no reason to think there will be a recession? Unless you are a professional investment manager with quarterly performance measurement, or you need the money within 12 months for some personal reason, the only reason not to be 100% invested in shares or property is because you think there will be a recession and a bear market. And if you have all your money in growth assets, there is no need to rebalance your portfolio unless you want to limit your exposure to a particular industry or sector. Then again, if your percentage invested in, say, biotechnology has gone through the roof thanks to CSL, maybe you were wrong to impose an arbitrary allocation to that sector. I mean, should you really sell some of your CSL shares, having bought them for $35 and watched them double? Of course not! This is still a great company, carefully using the cash flow from its blood plasma commodity business to build a portfolio of highly lucrative immunisation drugs such as Gardasil and flu vaccine; this is a company that might build your family’s wealth for decades to come. The other commonsense point that David Moore makes — too often overlooked — is that long-term performance is a pretty fair guide to what might a good thing to hold on to. Buffett also uses a commonsense approach, which is somewhat more complicated; that is, “intrinsic value”. He says the intrinsic value of a company is the present value of all future profits: he will buy a company if its market price is significantly cheaper than this figure (and then hang on through thick and thin). Intrinsic value is difficult for a small investor with little in the way of valuation expertise or software tools although our friend Roger Montgomery of Clime Asset Management has come up with a tool called “StockVal”, which uses Buffett principle to value companies, and which we will soon be featuring regularly on Eureka Report.. There is a saying in investment markets that past performance is no guide to future performance, but that’s one of those truisms that isn’t entirely true. In fact it’s usually, but not always, a pretty good guide, whether we’re talking about companies or managed funds, and in the absence of sophisticated valuation expertise, it’s about all we’ve got. |
Unbalanced portfolio