Subject: Re: Barron's ... oops. market not that overpriced
Philosophico-investment question for Mungofitch:

Hmm, is that my specialty? : )

This is the bit where I see some space between your thinking and mind. You mention:
1) Cap-weight means you own the same fraction of every company you own...

But this isn't right. You're owning the same fraction of the market cap of every company. But price (market cap) and value (the business reality) are usually different. There are indexes which attempt to hold the same fraction of the actual value of every company, often called "fundamentally weighted".
This is a nice summary, provided you don't place too much weight on the fourth section which is mainly claims about how fabulous their product is.
https://www.valueweightedindex...

Because of this distinction, the cap weight can be better thought of this way, divided into three types of holdings:
For things that are currently fairly valued, you have an allocation that is proportional to the firm's size. That should do fine.
For things that are currently undervalued, you have an allocation that is smaller than the amount that would be proportional to the firm's size. A missed opportunity to make a bit from mean reversion of valuation levels.
For things that are currently overvalued, you have an allocation that is larger than the amount that would be proportional to the firm's size. This will lose you money, sometimes a lot.

If some very large firms are currently overvalued (always slightly true, occasionally VERY true), effect #3 results in a very large dollar allocation to overvalued stuff. This is not something that is desirable.


Ignoring trading costs my intuition is you would get around the same result for daily weekly and montly rebalancing, and might start seeing a difference for quarterly or annual rebalancing.

Oddly enough, this can be measured, if you have access to a really good database and tester. No, it's not equal. There is random noise in market valuations at every time scale, and rebalancing more often gets you more because you can capture really tiny gains at a very high frequency...before trading costs. Shorter periods give higher returns, but at a shrinking incremental benefit as the times get shorter. Plus, there seems to be a rough price mean reversion period bell curve: things get overvalued for only so long on average. You want to capture a bit of the upswing, but get out before the down cycle, so there are hold periods that work better than others even without considering trading costs. In practical terms, trading costs matter a lot, and what matters even more is whether other folks are doing the same trade at the same time. Presumably a lot of people are taking advantage of the fact that RSP does its trades quarterly on precisely known dates, causing them a lot of drag. Plus of course the same drag effect that the cap-weight S&P has from pre-announced additions and deletions that get front-run. FWIW, based on a whole lot of tests (that may or may not be very meaningful), I use a 10 month rebalancing cycle in my own quant portfolio. I recalculate positions every 2 months, but positions that get held over several cycles in a row don't get trimmed back to the size of the average position until the 10 month mark.

The other intuitive gap from equal-weight I have is, are you sure you are better off selling the shares you own in companies that are seemingly rising more each year than most of your other stocks?

This ties into the previous comment. Obviously in an ideal world you would like to ride winners as they grow, but that is REALLY hard to do. Why is it hard? Because you want more and more money allocated to firms which are growing in true value, but only those not growing in price any faster than their value. Assessing true value is extremely difficult. The problem is that things getting overvalued among those rising in true value quickly is more common than not. So your first focus should be on avoiding having large bets on bubbly things, which (by contrast) is really easy to manage: you can't be overweight overvalued things if you're not overweight anything. Just don't have any big positions. Yes, it cuts out being overweight the best deals which is in general almost impossible to manage, but more importantly, it cuts out being overweight the WORST deals. Statistically, skipping big losses is more important than having a big position in winners.

The average stock in the average year-or-two goes up in value quite a bit. That observation alone is enough to make for a good investment strategy. There has been a lot of press over a study showing that over the long haul the great majority of stocks contributed nothing to the current value of the indexes, but that's a bit of a red herring. The explanation of the mismatch is only clear when you remember that when a firm ultimately dies, it is usually in a relatively short period relative to the length of the history of the firm. Imagine that the average public company has (say) 9 years of "nice" followed by 1-2 years of "oops", then out. Imagine thousands of such firms, out of sync with each other in terms of their life cycle and their cycle lengths. Imagine picking a big random sample from that group and holding for a year. On average you will get a lot more winners than losers, because stocks experiencing an "oops" year are rarer than those that aren't. So, even if it is true that the great majority of firms are worth nothing if you hold them forever, that observation doesn't matter unless you do in fact hold them right through senescence and death. A portfolio of randomly picked "plausible" firms (index inclusion is a simple way to start), held for a year or two, then (importantly) completely reconstituted, does amazingly well. Personally I use "loaded" darts, trying to do a tiny bit better than average quality picks, but that's just for bonus points. My quant portfolio is equally weighted, currently about 72 stocks.

Jim