How to carry out rebalancing if you invest in individual stocks to improve your wealth returns with less volatility
I polled my facebook readers on what I have not really covered at Investment Moats and one common question is how I carry out rebalancing.
Specifically, is rebalancing different if you pick stocks instead of a low cost index ETF?
Before we start lets get some things out of the way.
Asset classes mean revert not individual stocks
The main reason why you rebalance is that prices in asset classes (cash, bonds, equities, commodities) swing from overvalued to undervalued due to supply and demand, technology changes, mass psychology.
If you have determine a 60% stocks and 40% bonds allocation based on your risk adverse nature, markets will swing up and down and that allocation will change.
If you do not bring it back to parity, your portfolio may be overly risky or conservative.
One thing to note we are talking about asset classes as a whole.
When you invest in individual stocks, Its different. Your stock can go to zero, but as an asset class, equities cannot go to zero.
Invest in individual stocks versus equity funds
The main reason you will invest in individual stocks is that you can control your costs as oppose to expensive mutual funds / unit trust, but also that you think you are better at selecting better stocks than the market (index)
You believe you can outperform an index.
That is why you do not rebalance based on individual stocks. That somewhat counteract the reason you invest in individual stocks.
Rebalance by asset class correlations
The reason why it’s a demarcation between stocks, bonds and cash is because they are classified as asset classes that are uncorrelated.
Different bonds will have their own individual risks, but will also have risks that all bonds share such as interest rate risk that have a greater profound effect compare to individual bonds.
Similarly, your stocks may be govern by the profitability of their business in the next 10 years, but they are affected by systematic events that affect equities as a whole.
Do factor in to rebalance different groups of assets that have different correlations.
It is usually stocks and bonds because when stocks do well, bonds do not. When commodities do well, cash gets eaten by inflation.
But on a long term, the asset class must go up to make this meaningful to invest in. If not what is the point of investing at all.
Discipline way for buying low and selling high
As with equity funds, periodically you will review if you portfolio have veered out of the x% stocks, y% bonds, z% cash allocation.
An outperformance in one group means that the market that there is increase chances of a mean reversion of that asset class on the horizon.
Rebalancing by selling, or under-allocating means a discipline way of selling high.
When there is an abundant build up of cash, it means you may be overly conservative and not taking enough risk. Rebalancing by buying more bonds or equities brings the portfolio back to the desired allocation.
Step 1: Determine your asset allocation
The first step is to determine your percentage to allocate to for each asset allocation.
Each asset classes can have different rewards versus their risk, which in portfolio talk, means volatility.
Know your risk tolerance
As an investor, you have different tolerance to this volatility. You may not know what is your tolerance but it matters a lot.
Some folks (including me) thought they can stomach a 50% fall in net worth easily. The great financial crisis make them see the reality of it. They sell out at a low and refuse to buy at the low.
- Stocks: High returns but subjected to +/- 40% movements in the short run.
- Cash: Low returns but very very low volatility.
- Bonds: Medium returns and subject to +/- 20% movements in the short run.
Asset allocation changes
The level of volatility you can take varies when life changes. When your portfolio is small and perhaps when you are young you can take more risks so you can go for a 70% stocks, 30% cash allocation.
But when you are 60 years old, I don’t think you will want that allocation. You need the money soon and an impairment of 50% to your net worth can put a lot of cash flow problems on your shoulders.
For myself, the great financial crisis have thought me much about my risk tolerance. That I overestimate it.
While concentrating picking individual stocks, I neglect to see the benefits of certain asset classes like preference shares, and bonds, how their lower volatility can compliment my risk adverse nature.
At my age the asset allocation should be a 70% stocks 30% bonds allocation if I am using a unit trust or ETF. I am more risk adverse, so I should favor a 60% stocks, 40% bonds allocation.
But if you are picking stocks, liquidity is important and that is where having cash is good. Cash is like a call option that you can exercise in market downturns to purchase individual stocks or equities on the cheap.
If I were to favor a stock and cash portfolio, I will lean towards a 70% stocks, 30% cash mix. More stocks to take more risk since cash have lower returns than bonds.
Yet have enough to rebalance in a market down turn.
Step 2: Adding additional funds to your portfolio
As working people, we are determined to “Pay yourself first”. That is why you funnel X amount of your disposable income to “Wealth Building”.
So if you funnel $1500 in monthly, add that to your cash asset allocation.
Assuming your allocation is 70% stocks, 30% cash, the current market can mean that the value of your allocation (note value not cost) becomes 85% stocks, 15% cash.
Based on your allocation, you should be raising cash. Thus the easy decision is to bank in the $1500 into your cash asset allocation, to build it back to 30%.
Intuitively, it means “prices may not be as cheap as it is used to, I am being discipline and not buying at a high.”
In a market downturn, the allocation becomes 40% stocks, 60% cash, mostly due to your stocks losing a massive chunk of value, your $1500 will go to picking undervalue individual stocks.
Initiatively, it means “price have been beaten down and if I buy now, I am buying low”
Step 3: Buying Selling securities in your asset classes
The decision to buy and sell the underlying securities should be taken based on your evaluation of whether it measures up to your original expectation of the investment.
It is an entirely different matter all together from portfolio management, which we discuss more here.
If you have a Starhub or Berkshire Hathaway, that is maintaining its edge, and you do not see a reason to sell, then just let it run.
If you spot a good bond that yields 8% but the risk is lower than market expected and priced well, you can choose to buy it.
Just so you know that you may veered off your targeted allocation of 60% stocks, 20% bonds, 20% cash for example.
You then may want to look at each securities individually, which is least appealing, which you have made a wrong move but still earning and you may want to replace it with this more appealing investment.
Step 4: Review your asset allocation mix
The investment world changes such that there may be a viable alternative asset class that can boost your portfolio and at the same time lower its volatility.
This can be private equity, traded endowments, variable annuity, timber, business trusts.
Periodically, preferably quarterly do a re-evaluation whether you can better align your wealth portfolio to your risk adverse nature and your life goals.
I think there are no hard and fast rule to which asset allocation is the best. Although, for me, asset allocation is more important than individual stock selection.
Right now I am under invested. I would have handily do much better if I don’t pick stocks and just lump, 30% from cash to deploy in an STI ETF or Vanguard World Stock Market ETF. That more or less aligns to my financial goals rather than vex about the risk of individual companies.
In this case I missed out on the bigger picture while nit picking on small things.
Thus my view is that having the right allocation mix at the right time is more important than the individual asset securities selection.