Old Ideas and New Ones
RCM Managed Asset Portfolio
By Christopher Chiu, CFA
Old Ideas and New Ones
Charlie Munger used to say the hardest part of learning wasn’t coming up with new ideas but getting rid of old ones. Old ideas are hard to displace; they work on some level. They provide cohesion to existing practices. But when weighing the merits of old ideas, we need to recognize their limits as well.
One idea that hardly gets examined is the practice of wholesale portfolio rebalancing. The benefit of portfolio rebalancing is that it limits risk, since you can never lose much if you are constantly taking profits on stocks that have had a gain. But the advocates of rebalancing hardly ever state the negatives that can come from continual rebalancing.
They advocate rebalancing because it is considered a best practice. It seems obvious because everyone does it. But as Mike Lombardi said of Patriots coach Bill Belichick, what made Belichick great was he was the master of the nonobvious. (In Super Bowl 49, with time running low and the Seahawks on the verge of scoring the go-ahead touchdown, Belichick decisively decided not to call time out to set his defense as most coaches would have done. This was because he saw the Seahawks offense in confusion about what play to run. The Seahawks made a mistake on the next play as Patriots cornerback Malcolm Butler intercepted the ball on the goal line to stop the Seahawks go-ahead score and preserve the victory.) If we strive to be better than the rest, we should all try to master the nonobvious. By being unconventional you give yourself a chance to get better returns. But if you follow conventional wisdom, you get conventional results.
Conventional Wisdom
If you follow conventional wisdom, you rebalance your entire portfolio periodically. Imagine you have a portfolio worth $10,000. It includes a 10% position in UNH, which goes up 50% for the year. All else equal, that original $1,000 of UNH grows from 10% of your portfolio to $1,500 or 15% of your portfolio by the end of the year. But suppose you then rebalance and sell off enough of UNH so that you again only own 10% worth of it. And then to complete the rebalancing, you put that realized gain into the rest of your portfolio.
Now, there may be many reasons for making this sale. Perhaps you know for sure that UNH will go down significantly. But if you do not have perfect knowledge about the future, what you are doing is selling part of one of your better positions and putting the money back into the rest of your portfolio, which has not performed as well. Looking at it from the outside, a neutral observer might say that in selling off some of the UNH position you are acting as if that 50% gain came from luck and not from your skill at picking a good long-term investment since you act as if you do not think UNH will do better than the rest of the portfolio in the future.
Negatives of Conventional Wisdom
Rather than continual rebalancing, the unconventional strategy would be to allow your greatest winners to run. The way that math works is that if the $1,500 position in UNH grows again the next year, the result will be more than it would have been if the amount was the rebalanced $1,000. This is because you are growing off of a larger base ($1,500 being greater than $1,000), which you shrink when you continually rebalance.
This is why rebalancing, which involves constantly selling your gains, can prevent you from achieving what you would have achieved had you left things alone and let your winners run. And this difference can be significant over a long period of time. This is a negative that doesn’t get expressed much in the investment industry.
What gives me so much confidence in saying something so contrary to conventional wisdom? As portfolio manager of course I would want to improve my craft and of course I would then try to see what great investors have done in the past and what has worked for them. And I would also study the great investments that have worked over long stretches of time and find, if I could, reasons why they worked during these spans of time. What I have observed is that in a long-term portfolio strategy, the greatest part of the portfolio gains is the growth on top of the growth that has already occurred. Constant rebalancing works against this compounding effect.
We Still Rebalance
This is not to say we do not practice rebalancing in our portfolios, but we do so more selectively. Our bias in recent years in the Strategic Knight and GEIP is to let a lot of our winners run and not to sell them, especially if these businesses prove to be uncommonly strong. Some of them may become the greatest performers for a portfolio if they are left alone to grow. When we have rebalanced too much in the earliest years, we have at times come to regret it because the portfolios might have been better had we just left the winners alone.
All of this is not to say that rebalancing does not have benefits that should be ignored. Reducing concentration and promoting maximum diversification does lessen the possibility of loss. But this should always be weighed against the possibility of gain. The forces of diversification which allow you to lessen losses also prevent you from maximizing gain when you have found the right investment. Starting from small beginnings, the Walton family didn’t become one of the wealthiest families in the world because they continually rebalanced their assets by selling their gains in Wal-Mart every year. Had they done so they would never have come close to achieving their level of prosperity.
