No. of Recommendations: 11
This is gambler's fallacy. ...
Short term, IV stays the same, price pops up by a random number. Why should it go back to IV? Slot machines have no memory.
Because the stock market isn't a slot machine, it's a weighing machine. Prices aren't random, they are mean reverting (admittedly slowly and weakly) to fair value. Most stock prices visit it from time to time. And even if they stay far from it for a long stretch at some high or low value, there will be oscillations about that abnormal level.
It's easy to prove to yourself: Pick any stock history for which you have an estimate of fair value, which is presumably fairly smooth. Let's say you use your cyclically adjusted EPS estimate as an example.
Check the buy and hold returns for some long stretch of time.
Check the return for the same stretch of a strategy that periodically (weekly, whatever) rebalances to a dollar value equal to a constant times your smooth EPS number.
The second strategy will have a higher IRR. And of course you will have much better risk control: you'll never own a bubble-sized allocation to a bubble-priced stock.
In the degenerate case of a stock with no change in its intrinsic value estimate you will have a constant number of dollars invested in the stock, and the breakeven price on that block of stock will gradually fall because you will be periodically selling a small piece at a higher price and buying a small piece at a lower price over and over again. Over time the position will be throwing off a slow net stream of cash.
I'm not saying this is the best strategy in the world, but it does what it says on the tin. The biggest drawback is that it presupposes that you have a material cash allocation and you don't have a strong opinion on exactly how much of your portfolio it accounts for: not everyone is in that boat. Oh, and don't try it with a stock which has any conceivable chance of actually falling in intrinsic value! As you note, intrinsic value can change abruptly--you can lose money on those no matter what your position sizing strategy is. Just use the strategy on picks where the trajectory of IV (though not necessarily the slope) is the steadiest you can find.
Jim
