My Uncle Roy loved to tell (and retell) the following joke: “Two birds were sitting on a fence. One was named ‘Pete;’ the other ‘Re-Pete.’ ‘Pete’ flew away. Who was left?” We’d answer “Re-Pete (repeat).” Then he would say, “Two birds were sitting on a fence…” And so on and on as long as we would answer him. Even now I have to chuckle at that one.
I am a firm believer in the benefits of repetition. I truly appreciate when the people I respect take the time to remind me of best practices, be they health habits, exercise, interpersonal relationships, communication styles, and yes, even basic investment principles.
I think most people understand at some level the basic investment notions of diversification, risk management, valuation and so forth. And yet, I often see otherwise highly-intelligent people with less-than-highly intelligent portfolios. Sometimes the portfolio is simply unfocused – a smattering of well-known names, probably selected due to the company’s high profile, attractive products or good standing in the corporate world. Sometimes the portfolio will be focused on one single idea, such as high-dividend-yield stocks, energy stocks or the biggest names from one overseas country. Sometimes I meet the hyper-indexed portfolio, put together by someone who thinks 1) the market is efficient and 2) outperforming the market is impossible (both of which are subject to debate). Where one broad index fund might be sufficient, the hyper-indexer will own 20 – “just to be safe.” Sometimes, I meet a portfolio with a handful of stocks, one of which represents about 60% of the total. This investor may think the portfolio is diversified (Hey, I own 7 stocks!), but this kind of portfolio may be the riskiest of all the sub-optimal portfolios I see.
For the most part, these kinds of portfolios are underbalanced, undermanaged, and under-diversified, characteristics that often lead to underperformance and can undermine one’s long-term financial plans.
In order to be truly balanced, a portfolio needs a number of key elements. First is a fixed asset allocation. Many will debate this point with me, but I think asset allocation should be based on a person’s risk tolerance, not on how he or she feels about the markets. One’s asset allocation may vary over a lifetime, as core risk tolerance changes, but it should not be changed during a market cycle. The second key element is adequate diversification. A mutual fund portfolio with as few as 8 funds may offer sufficient diversification. An individual equity portfolio should have at least 30 names to reduce non-systemic risk. Owning a whole lot more than 30 names rarely provides additional meaningful risk reduction. The third element of a portfolio in balance is some kind of rebalancing regime. For example, when one asset class becomes a higher percentage of one’s portfolio than the target allocation calls for, one should sell a portion of it, and put the proceeds into the other assets classes. In an individual stock portfolio, when one stock becomes much larger (through outperformance – yay!) than others in the portfolio, what should one do? A disciplined rebalancing routine would have one sell a portion of that stock and deploy the profits elsewhere among existing stocks or even into new names.
This rebalancing may seem a bit contrary to some of the old “rules of thumb” we hear sometimes about investing, such as “let your winners run,” or “cut losses on your losers.” In my view, there are so many such “rules” that following all of them would be nearly impossible. Sometimes they might apply to short-term traders, but not to long-term investors. Following the guidelines I’ve suggested will more often result in “buying low and selling high,” something we can all agree is a good thing.
But what about all those capital gains generated by “selling high?” Well, as my good friend Scott Bush often would say, “No one ever went bankrupt by paying capital gains taxes!” The good news with realization of capital gains is that you are making money! The better news is that the U.S. IRS taxes long-term capital gains at a lower rate than ordinary income. As painful as paying capital gains taxes may be (I would argue this is less pain than losing money!), not rebalancing will often lead to a portfolio that is less balanced, and hence potentially much riskier than the investor would like.
To paraphrase an old saying, “The market giveth and the market taketh away…” Sometimes it’s wise to take profits when the market offers them to us.