Rebalancing is the process where investors sell an asset that takes an above average allocation in their portfolio, and use the proceeds to purchase an asset which has a below average portfolio weight. Many investors are told that they need to re-balance their portfolios regularly. The benefit from rebalancing is risk reduction. In my investing, I do not practice re-balancing. This is because I view re-balancing as a perverse process where I end up selling my winners, in order to add to my losers. Re-balancing is a form of market timing, and runs opposite to my belief of letting the best performers run for as long as possible ( until that dividend is cut). I am going to provide more detail below.
I spend a lot of time trying to find attractively valued companies, and then poring through financials, reports and performance statistics in order to determine if I want to purchase them or not.
Even if I do a great job of selecting the best companies, chances are that things will change in some way 1, 5, 10, 20 years down the road. A company can become terribly overvalued, or it could hit some unforeseen/carelessly researched by me event and end up with deteriorating financials. These deteriorating financials could lead the management to cut or suspend distributions to shareholders. I expect that these situations would not be the norm in a carefully selected group of stocks however. At some point, it is important to remain objective, and remove the bad apples. Capital is best allocated outside the bad apples.
Selling companies is the most difficult part of investing. I usually sell after a dividend cut, a cash buyout, or extreme valuation such as a P/E over 30 - 40. However, contrary to what most investors do, I never re-balance.
I expect that the majority of the companies I purchase would slowly improve revenues, earnings and dividends over time, while trading at a reasonable band of earnings multiple and dividend yields over time. For example, a company that earns $1/share this year that trades at somewhere between 15 to 20 times earnings, will trade around the $15 - $20 range within one year. If the company earns $1.05/share in the next year and trades at a P/E of 16 – 20 the range would be from $16.80 to $21. Of course, nothing is certain nor linear in life. Therefore, a company with growing earnings could trade at high or low valuations over time. However, as long the company keeps earnings more each year and it is not too terribly overvalued, I would restrain myself from doing anything. Actually, once I identify a quality company that grows earnings and dividends over time, my job is not to micromanage anything. My job is to sit back, monitor the company, and enjoy the rising wave of prosperity over time.
I usually take dividends in cash, and let them accumulate up to an amount equal to approximately $1000. When I didn’t pay any commission, my lot size was approximately $250/trade. This meant that as soon as I accumulated $250 in cash in my portfolio, I would buy an attractively valued stock. Now the lot size is approximately $1000 - $2000, depending on broker and relative attractiveness of an investment situation. I usually try to allocate equal dollar amounts to my portfolios, but I realize that over time things are going to differ substantially between positions. However, if a company also ends up accounting for an above average percentage of my portfolio, I simply would not add any funds to it. I let accumulated dividends and new cash added to the position in new or existing positions that are cheap. That way, over time, these previously highly weighted positions would fall to normal levels.
Thus, while I do not re-balance, I do manage portfolio weightings. In a portfolio consisting of 40 companies, the average position size could likely be 2.50%. If a certain position exceeds 5%, I would stop adding money to it, even if it is the best dividend stock opportunity at the time. In addition, I would allocate dividends generated from that same company elsewhere. If a position is between 6% and 10% of my portfolio, I would still refrain from "re-balancing" or selling as long as I plan on adding new funds to the portfolio. If I am still adding funds to the portfolio, my portfolio will increase in value, and therefore the relative weight of that top position will decrease over time. Another tool I have at my disposal includes the fact that I take all distributions in cash, and then allocate them in the best opportunities available outside of my largest five or ten portfolio holdings.
Even if I don’t add any more funds to my portfolios, I would still refrain from re-balancing positions back to equal weighting. Selling a company just because it has gone up in value does not sound appealing to me, since it triggers taxable events, costs brokerage commissions, and requires more of my precious time than I can afford to dedicate to mundane tasks at this moment ( and keeping track of taxes which are more complicated as a result of rebalancing is an example of such a mundane tasks). This punishing of companies whose stock go up is contrary to my investment philosophy of buying sound businesses with favorable long-term economics, and then letting the dividends roll into my accounts. Of course, if the companies cut dividends, get bought out for cash or trade at ridiculous P/E’s of 30 or 40 I would probably start selling off slices of my positions. For MLPs and REITs I would look at DCF and FFO multiples. Re-balancing also strikes me as market timing. Few investors are good at timing the markets. Rather, it is time in the market, not timing the market, that delivers the most value to the long-term investor.
You are increasing the amount of work for yourself by selling companies because they moved in price. When you only look at prices, you are essentially speculating. Re-balancing where you sell investments because of price, not because of some change in fundamentals, is market speculation, which will make your broker and your local tax authority better off. You are also taking on added the risk that the companies you added to will do better than the ones you sold from.
Selling overvalued stocks should never be an automatic event either. For one, a company might have a high P/E ratio, because it recognized a one-time event caused by some arcane accounting rules. Or a company might be up in price, but the fundamentals support further growth in earnings and dividends, that might actually make it a steal today. Other times, a company might look undervalued at the peak of the economic cycle, but overvalued at the bottom. Cyclical stocks like oil and gas or metal companies are notorious for this. The other risk I am running is that I sell a company that looks overvalued but prospers in the next 30 years, for a company that looks cheap but doesn't really improve fundamentally in the next 30 years.
In addition, selling a company that has gone up in price to add to a company that has gone down in price might not be a very smart strategy, as you are punishing winners and rewarding losers. Most investors would find that argument not too convincing, particularly since it runs contrary to the popular belief that investors should buy low and sell high. I would let you in on a little secret:
I like to buy high, and then hold for as long as I can collecting dividends, and hopefully never sell. But when I do sell, the goal is to sell at a much higher price, and generate a large amount of cash in the process through dividends. This happens in less than half of investments, but when it does, it will more than compensate for the situations where I bought and lost money, and then some. A much higher price is a result of rising fundamentals. Buying a stock at an all-time high is totally fine with me, as long as the entry price is attractive and fundamentals show a promise. Remember that we are all buying stocks today and hope their earnings and dividends increase from here. As a result, the goal of our dividend growth strategy is to find investments that will frequently be in uncharted waters on the upside. Of course, if I can purchase a stock with improving fundamentals when prices are low that is an added bonus as well. Learning as much as possible about investing, and training yourself to keep an open mind about investing opportunities, could pay off big time for you.
Back when I added to my position in Realty Income (O) at the end of 2011, the stock was trading at all-time-highs. However, the company was adding properties to its portfolio, and was determined to boost FFO/share and dividends/share. I viewed Realty Income as overvalued up until late in 2012, when it announced it was going to purchase ARCT. Then it boosted FFO and dividends per share substantially, and therefore the stock appeared attractively valued at again. Currently, the stock is a little overvalued, but I would hold onto it so long as it continues growing the asset base that will pay rising monthly dividends to shareholders. However, if the stock gets too overvalued and starts yielding 3.50%, I would sell a portion of my holdings. At 3% I would sell more of my Realty Income stock, and would probably be left with 1/3 of the original stock position. If I understand their business model however, I am perfectly fine if the company keeps adding properties from here, and raises dividends in the process, while the stock trades at a band of high and low prices. If I didn't own so much Realty Income already, I might have considered adding to Realty Income if it yields more than 5% again. Because of that, I recently added to my holdings in W.P Carey (WPC), HCP (HCP) and Omega Healthcare (OHI) for a second month in a row.
My models for investing work better with companies which do not experience too much volatility in earnings, and which have the competitive advantages to command premium prices for brand name products and services. As a result, selling a company like Coca-Cola (KO), which grows earnings in the high single digits every year might only be feasible above 30 - 40 times earnings. Holding on to this type of company might be the wise strategy for as long as it makes sense. Selling off Coca-Cola simply because it has gone up relative to another company might not be the most prudent decision, especially if done automatically, without taking into account fundamentals, stability of earnings , and expectations about growth.
As an added bonus, I have included a chart from a Forbes article. The chart shows the results of re-balancing within a portfolio that holds only stocks and bonds. We all know that stocks have higher expected returns than bonds. The financial advising industrial complex sells retirees on the idea of rebalancing in order to reduce risk. The problem, as the chart below shows, is that it ends up resulting in a smoother ride at the expense of much lower returns. This is not difficult to understand, because if the asset that you expect to generate the best returns does indeed end up generating the best returns over time, you have to keep selling it off. You have to keep selling it off in order to maintain a certain target weight of stocks or bonds. Thus, you end up selling your best performing asset, in order to add to the asset with the lower expected returns. Based on the article it was found that re-balancing subtracted from returns.
Full Disclosure: Long O, WPC, HCP, OHI, KO
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