Sunday, June 19, 2011

Importance of rebalancing

I am sure many of us have seen our stocks turned from very positive returns to negative returns in a short period of time. During my experience, I have personally faced such encounters. Just to name a few, they are Healthway, Cosco and Capitaland. At the peak of their traded prices, my returns in these stocks have reached +66.7%, +172.3% and +80.8% returns respectively. Now they are valued at -23.1%, -41.1% and +10.5% returns respectively. My potential returns have diminished because I didn’t get to sell them earlier. Of course it is regrettable when you look back in the past or on hindsight. But how can we actually overcome this diminishing return effect in future?

One possible method I can think of is rebalancing. Investopedia explains rebalancing as

The process of realigning the weightings of one's portfolio of assets. Rebalancing involves periodically buying or selling assets in your portfolio to maintain your original desired level of asset allocation.
For my case, I don’t buy into bonds. Most of my cash are invested into stocks as I am a high risk taker. So what I can do is to switch into cash when the market is moving up or switch back into stocks when market is tanking. The most important point to take note of is that the switching should be done on a continuous basis and not at one shot. For example, when market goes up by 10%, I should be switching 10% of my stocks into cash. When market goes up by another 10%, I must switch another 10% of my stocks into cash. The reverse should be done when market tanks. The bottom line of rebalancing is, there should be some kind of system in selling your profitable investments and buying into the less performing investments. Just like for my case, the two assets are stocks and cash. So I should be switching between these two assets. The rebalancing technique I have mentioned is another method of rebalancing in my opinion. I am making use of the market return to trigger my switching decisions. Alternatively, one can also follow the investopedia definition by using weightage as a trigger in making switching decisions.

Now we know there ought to be some system of rebalancing so as to realise some profits and plough back into the less performing investments. But the question is, which are the stocks to sell when the market is going up? Here are some basic techniques in identifying the stocks to sell.

1.Sell those profitable stocks that have run up too fast within a short period of time.
2. Sell those profitable stocks that are overvalued.
3. Sell those profitable stocks that have reached your target returns.

At the moment, market is pretty volatile and uncertain because of US economic recovery, Europe debt crisis and China slowing down. For now, no one can be really sure if the market has bottomed or not. I didn’t manage to sell my profitable stocks during the recent up market but now I am adopting a slightly different rebalancing technique. That is I am slowly trying to sell my most profitable stocks as the market is tanking. In such a way, I can plough back my cash into stocks should the market undergo a 50% plunge like in the recent financial crisis. If the market moves up from here on, I will adopt the rebalancing technique that I mentioned in the earlier part of this post. Either way, I must learn to start selling my profitable stocks.


Anonymous said...

Mike, for your own good please don't just look at price alone ("profitable stocks") but PE ratio, dividend records, business prospects etc.

Musicwhiz said...

Hi Mike,

I know this might sound harsh - but if you keep focusing on selling the profitable stocks only, you'll end up with a whole portfolio of loss-making ones. Generally that's not a good idea to make consistent returns when investing. The idea is to analyze the business deeply, and sell the losers who falter while keeping the winners who have strong business franchises.

Like what Anonymous has said, focus on the business,and not the price.

OK, paiseh if I sound preachy!

Take Care!


Mike Dirnt said...

Thanks guys for your comments.

So it means you guys dont believe the benefits of rebalancing. There are countless research done on its benefits. I understand the principles but just that i didnt try to practice.

Anonymous i did mention about valuations as a basis for selling. So its not due to price alone.

MW let me give you a scenario whereby rebalancing is very beneficial. Lets assume you have 2 stocks in a portfolio with 50% allocation initially. One stock has risen 80% and the other stock has fallen 20%. Aslo assume both stocks have similar fundamentals and business prospects, rebalancing means you should switch your winning stocks into losing stocks. "Past winners are tomorrow losers and vice versa."

Jeremy Ow said...

Hi mike,
Past winners can be tomorrow losers and can also be tomorrow even better winners. Similarly, past losers can be tomorrow winners and can also be tomorrow even worse losers.

There is nothing perfect nor definite in this world. As investors, we try our best to analyse the businesses we invest in to forecast the future of the business. We still need to constantly monitor our invested businesses as nothing is guaranteed in this world.

As long as a business is growing strong in fundamentals and remains acceptably profitable, one should continue to be invested in such businesses. Take market gyrations as a way to buy some more shares in such good businesses when they are undervalued. I will instead take a counter-intuitive way of selling out non-profitable businesses with deteriorating fundamentals during a downturn and channel my funds into buying good businesses that are undervalued during a downturn.

If a business is lousy (in terms of deteriorating fundamentals beyond repair), do not keep it even beyond a day. Sell out even at a loss in stock price and channel funds into good and profitable businesses when they are undervalued enough (esp. during a downturn.

Short-term loss can be made up easily by long term profitability as long as one consistently underpays for good businesses and remains invested in them long enough as long as they remain profitable.

Just my sincere two cents worth.

Musicwhiz said...

Hi Mike,

Thanks for your example. But theoretical is different frmo practice. In practice there are no two companies with the same business model, prospects and fundamentals. Hence, we invest with limited knowledge and have to monitor the business for each specific company.

Rebalancing makes sense when you feel everything is over-valued, and you somehow spot an under-valued company. I think that is a case which makes sense (to me at least).


Mike Dirnt said...

Hi Jeremy,

You wrote some valid reasonings regarding fundamental investing. IMO its still a far from perfect strategy. Even though a company can be doing well, we still need to learn how to take some profits from the company so as to recycle/channel the funds into other potential companies that appear to be more undervalued or those we think that can generate higher returns.

Let us say we have invested in a company for several periods and they have translated into enormous amount of returns to us. The higher this unrealised return becomes, the higher the risk the risk it can be wipe out and the higher the need to protect its return by selling them. I am sure you know stock market can be very cruel to us. Whatever returns you achieved in a few years can be wiped out in a few months easily and never recovered. There are some sayings that nothing lasts forever and never fall in love with a stock. Though your definition of selling a stock refers to only the one that has deteriorated fundamentally, we should also try to take turns to sell those profitable ones to realise our returns even though they can still be a good company.

Jeremy Ow said...

Hi Mike,
Thanks for your reply. I agree with you and MW regarding rebalancing from the point of view of selling out grossly overvalued companies in favour of buying another undervalued company that has equal or better perceived fundamentals than the sold out ones.

The idea here is to sell out grossly overvalued companies that their valuations have reached ridiculously high levels that simply cannot be sustained based on their perceived fundamentals. I quote the example of such a company like Cosco Corporation when it reached the previous ridiculously high levels of more than $8 per share during last bull run. As an investor, he needs to think carefully at such price levels, is the price really supported by a worthy enough strong business fundamentals or is it supported by strong trading sentiments of the market participants. When the answer becomes clear, one will be able to make a sound decision to sell out it's shares at such ridiculously high levels since there is simply no fundamental logic for it's shares to continue trading forever at such ridiculously lofty price levels.

The same goes for the past glamorous internet stocks that sky rocket in their valuations based on sentiments rather than fundamentals and thus also goes through bungee jumping drop in valuations "overnight".

If one is unclear whether a ridiculously grossly overvalued stock will still sky rocket further since we cannot predict sentiments of the market, we can sell out slowly in tranches.

Thus, I agree that there is no one rigid way to invest. A good investor even though being knowlegeable, must be creative and flexible in thoughts as the market conditions are always changing all the time, just that the general pattern from ages past to now is always the same (stock prices going through periods of highs and lows).

Yours sincerely,
Jeremy :-)

Mike Dirnt said...

Hi Jeremy,

I think its unfair for you to quote about cosco being overvalued at $8 because with the benefit of hindsight.

1) how about those people who bought at $2 or $3 way before cosco became a spotlight before 2006? are they overpaying as well? i would say they bought at a good margin of safety but still their investment is sitting on a loss now.

actually in fact, cosco share price rise was in tandem with the huge amount and continuous of new orders up to the financial crisis. but then they got hit with a systemic (undiversifiable) risk and alot of new orders were cancelled.

2) valuation is very much of an art. so different people will have differing valuations on a company. even analysts can make wrongful valuations on a company, so how much more an investor like us?

so looking forward, i was just trying to find a system that can actually realise our returns without relying too much and solely on our own valuations/perceptions of a stock which may/may not be proven wrongly later on. remember it is wrong/painful to experience our stock returns to turn from positive to negative but it is NEVER wrong to realise some profits and take back the cash.

FoodieFC said...


thanks for the post and comments. really food for thought. All the best to all.