By Jeff Miller. Originally published at ValueWalk.
Periodic portfolio checkups and rebalancing are important processes for individual investors. Ben Carlson wrote today about Seven Strategies for Investing at Market Peaks. He avoids saying that the current market is “the” peak, but the title clearly captures the interest of investors with that suspicion. He lists seven different strategies, noting some pluses and minuses for each. Then he stops.
My mission is to go a step further, providing some criteria for making rebalancing choices.
Why now?
You can, of course, simply rebalance your portfolio to a preset allocation. Most people believe that they might try to do a little better, depending upon current market conditions. Is it really a market peak, for example?
There is some irony in the current interest in reviewing portfolio balance. When the market was registering big losses, many people did not even read their statements. The news was probably bad. They would do better by waiting out the decline. With the market hitting new highs, there is greater interest. “How am I doing? Is my account also at a record?”
Investors who have safe and sensible allocations are now wondering why they were not more aggressive. How easy this is to see after the fact! The long, gradual rally, without significant corrections, may have instilled a false sense of potential risks.
Picking Winners is a Key to a Successful Rebalance
This may seem obvious, so let me explain a bit. We all love winners. Two of my friends are experts at thoroughbred handicapping. Both made a six-figure income for many years, even after the 17% rake from the track. Did they have a secret?
Not really. It was what equity investors would recognize as risk/reward. The popular horse often had enough action that the odds were unfavorable. Complete losers should be ignored. Their strategy was to shop the market of contenders seeking good prices. They did not expect miracles of consistency. Any horse could have a “bad trip” or a bad day. You analyzed the fundamental ratings for each horse. You developed a range of possible outcomes. And from that, you looked for significant edge – what horse “investors” call an overlay.
Put briefly, a good bet is a good horse at a good price.
And so it is with stocks.
The Intuitive Process
The most attractive investment for the intelligent investor seems to be the one with the best return. You would also like to avoid any nasty drawdowns. Here is an actual example of choices available to investors based upon a track record of nearly twenty years.
For anyone looking at risk/reward, as measured by volatility, the choice is obvious. Is there a problem?
Whenever the results are too good – either in overall return or in volatility – something is wrong. You should expect some volatility. The key is to understand the reason.
Suspicious readers may have already guessed that the “mystery fund” was Bernie Madoff’s. (James Montier).
How Does this Skeptical Thinking Help in Picking Winners
Great investments require combining three elements:
- Fundamental values;
- Current price, and
- Risk.
Good news! Each is difficult to measure. If you can do it, even a little bit better than the market, you have plenty of opportunities.
If you have a strong method that evaluates with these three steps, you can do well on your own. An alternative is to buy a mutual fund with a manager skilled at finding values. In that case, your search for a winner becomes evaluating the manager’s performance.
Sometimes it is more helpful to start with obvious and natural mistakes.
Biggest Mistakes
- Not using a long enough time period. A good system is one that works in the long run, but even the best methods have streaks. For trading results, the right measure is the number of decisions, not calendar time. A high-frequency trader makes thousands of decisions per hour. It takes very little real time to get into the long run. A macro fund might make only a few key decisions each year. HFT’s are winners almost every day! This is the effect of millions of decisions with small consequences. A macro trader has fewer decisions, but makes much more when correct.
- Suitability trumps returns. If you choose a program that is too risky, you are likely to bail out on the first dip. A great return will not matter if you are not around to enjoy it.
- Competing with the market, or a benchmark, or a neighbor when you should focus on your own goals.
- Chasing recent returns. Picking what worked last year is the biggest of all mistakes. This means risk measures like volatility, as well as the overall gain.
What Works?
The excellent work of Michael Mauboussin explains why process is the key to investment success. Tren Griffin’s review of his “favorite” Mauboussin book provides a great summary of the key points. This chart captures an important part of the summary.
If you discover a good process – like that of Warren Buffett, for example – you can be more confident about the outcome. If you do not understand the process of the mutual fund manager (or your investment advisor) you need to do some homework!
Ironically this requires knowledge and skill that most investors have not developed. The cruel consequence is that techniques that normally work – looking at past performance on a chart, for example—are worse than unhelpful. They lead to performance chasing that causes most investors owning a mutual fund to trail the fund’s performance! Poor timing.
Current Examples
While rebalancing is different for everyone, I find that most investors these days have an excessive weight on utilities, dividend stocks, bond funds, and other members of what has been a successful trade. It is now a crowded trade. No statistical measure will provide a warning. The winners from the past all look good, and that is the trap.
Where to add to your assets? I do not see the current market as over-valued. Even if it were there are many cheap and attractive stocks. The excessive fear of an imminent recession has cyclical names, financials, transports, and homebuilders on sale.
Rebalancing is the quintessential case of buying low, and selling high.
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