Unlock Editor’s Digest for free
FT editor Roula Khalaf has chosen her favorite stories in this weekly newsletter.
Like many teenagers, I read The Dice Man. The idea of the protagonist of a novel making decisions based on the roll of the dice seemed rebellious and fun. I tried it too, but it didn’t give me the numbers I wanted, so I gave up immediately.
Then I went to college and my friend Trevor and I simplified things. We founded Yes Generation, a two-man club where the only rule is to answer in the affirmative to everything asked of you (with the exception of attending lectures, of course).
This approach to everyday life also failed. Therefore, it turns out that randomness and the same response every time are not good. In hindsight, I should have done the opposite of all the choices I made. Why didn’t the Korean president call me?
I studied liberal arts, not economics. He lived in the antipodes. I haven’t given that speech. I should have turned left and entered the car instead of turning right. Needless to say, selling the US stock fund I owned last year is also on my list.
The reason I always like constraints when it comes to investing is because I believe in the flip side of what feels obvious. Automatic rebalancing of portfolios in particular is usually done against every bone in the body.
Since there are more winners, we need to lower the weight of the winners again. Are there any garbage stocks that have lost you a lot of money? Be sure to press the “purchase button”. It hurts like a fire, but it’s fascinating in its simplicity and contradiction.
Unfortunately, rebalancing is mostly a claptrap. Not only in theory but also in practice
Rebalancing also seems to be verified by flow data. Investors are vulnerable to hype, being extremely bullish at the top of the cycle and extremely negative at the bottom. It’s the complete opposite of how you make money.
For example, in just the two months before the S&P 500’s peak in 2007, net domestic inflows were $20 billion, according to LSEG Lipper data. After the financial crisis, net outflows remained at $40 billion for nine months after the market low in March 2009.
A disciplined rebalancing strategy overcomes the temptation to buy high and sell low. If you wanted your portfolio to be 25% U.S. stocks, you could sell weekly or monthly, build up all your pre-crisis profits, and then use that cash to jump back in when everyone panics.
This is also why so-called robo investing makes sense to me. Similarly, with private equity funds, the fact that we cannot withdraw cash immediately (and therefore be able to buy cheaper assets when they sell) is key to their performance record.
All of them are wonderful. Unfortunately, rebalancing is mostly a claptrap. Not only in theory, but also in practice. An issue in the academic literature is the definition of wool. The problem for real-world investors is that buy-and-hold strategies tend to work better.
I don’t mean to offend any of you out there enjoying your weekend, but the big problem is that most studies focus on expected returns. These (as I wrote earlier) rely on a number of assumptions. The important thing is that the price “reverts to the mean”. Even if it declines, it will eventually recover, and vice versa.
Therefore, over a theoretically infinite period of time, a strategy that holds a volatile asset, sells it when it is above the trend, and buys it when it falls below the trend, would outperform a static portfolio. Masu. But it’s a truism.
Back on Earth, it’s impossible to know if your favorite stocks are crashing in some way. Furthermore, research by Cass Business School and others shows that it is the increased diversification of rebalancing that creates the fairy dust, not the trading itself.
More importantly for investors, expected returns may not normalize in the short term, as U.S. stocks have shown for nearly two decades. Those who ignored the textbook and managed U.S. stocks are ruining their rebalanced portfolios.
And we haven’t even mentioned the worst part: constantly rebalancing your holdings. Imposition of capital gains tax will seriously damage profits. Additionally, non-institutional investors like you and me are charged high fees.
The extent of the loss is a factor of tax rates, the magnitude of gains and losses, and how far the portfolio deviates from optimal diversification. This is a tricky calculation that requires more than fingers and toes.
Fortunately, we didn’t have to do that this year. That’s because, oddly enough, the weights of my five exchange-traded funds have barely changed. The reason is that my largest stock ETFs are all up 12-15%. Even though the return on government bonds was 4%, my exposure only decreased from 29% to 27%.
In fact, this is one of the reasons why I didn’t rush to buy my own good ideas in 2024, as I wrote about two weeks ago. None of my funds outperformed the others to the point where they screamed they should be eliminated.
And that’s never a good reason to sell. Evaluation is important. As a matter of fact, I am still satisfied with the absolute and relative attractiveness of Japan, Britain and Asia. Especially against America.
If you want to make room for a new fund or two, top slicing is the way to go. There is no capital gains tax on my personally managed pension. Additionally, it makes little difference whether you pay fees for five funds or one fund.
It certainly feels like a good time to realize some gains. As my daughter Jean might tell you, risky assets like stocks are crazy thanks to Donald Trump. Year-to-date returns on my portfolio have finally reached double digits.
According to my ridiculously ambitious goal, I need to double my money by the time I’m 60. Of course, even if you invested everything in Bitcoin this year, you would already be there.
The author is a former portfolio manager. Email: stuart.kirk@ft.com;Twitter: @stuartkirk__
