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A while ago I diversified a little away from BRK, currently owning around 10 different stocks (2 of them based on Jim: DG and KMX). I tried to value each of them based on current Market Cap + Revenue and expected Growth + Op.Margin during the next 5 years, resulting in the multiple of expected profits in 5 years one has to pay today (also based on Jim).

A simple formula tells me, based on this "Cheapness Index", how many % of my portfolio to put in each of those stocks. As cheaper as more. If for stock X the multiple to pay now of the expected profits in 5 years is 6 then I buy double the amount of that stock than of stock Y where that multiple is 12 and which therefore has only half the "Cheapness" of X.

Based on a total portfolio value of $100,000 in the begining my table in principle looked like this:

Stock    Multiple    Planned %          Current %          Difference
                     of portfolio       of portfolio
Meta       3.8         3.0%                0,0%              +3,000
Carmax     4.0         2.9%                0,0%              +2,900
Verizon    6.7         1.7%                0,0%              +1,700

.......
.......

In the first months of this year I've done the buying accordingly, so in this example I would have put $3,000 in Meta, $2900 in Carmax and $1700 in Verizon.

Now here is the problem: Naturally those 10 stocks developed differently. Price and therefore market cap changed, one of the 4 variables determining expected "Multiple", the supposed "Cheapness" of each stock, which in turn determines how many % of the portfolio should be invested in it. The above example now looks like this (not exactly, because I did buy less Verizon than planned and sold some Meta calls):

Stock    Multiple    Planned %          Current %          Difference
                     of portfolio       of portfolio
Meta       4.3         2.5%                3,2%            -700
Carmax     4.9         2.2%                3,3%            -1,100
Verizon    5.9         1.8%                1,1%            +700

So to again reach the percentages each stock should be in this portfolio, based on it's supposed "cheapness", I now would have to sell some Meta and Carmax after their rise (because of them being a bit less cheap now) and buy some Verizon after it having fallen and supposedly gotten even cheaper than before.

If one thinks this through it makes no sense because: Market Cap changes every day. With otherwise unchanged expectations every single day "cheapness" changes and the portfolio needs to be rebalanced. Nonsense as it means the very moment a supposedly cheap stock starts to do what you expect, to rise, you immediatedly sell a bit of it.

How to handle this in practice?

No rebalancing at all also seems nonsensical because the whole point is to buy more when something is supposedly cheap. If it's price rises it gets less cheap if everything else is unchanged so at some point there should be some rebalancing by selling something not that cheap anymore for something else that's supposedly cheaper now. But when to rebalance? How often?

I think the theory is good.
If something has a higher price, it has a lower upside and a bigger downside in a fixed forward interval, so own less of it. And vice versa.

But...the thing that is more important is how sure you are of your outlook on each investment.
(then decreased by the "I was sure, but I was wrong" factor)

For two random picks, I love DG and I love BRK.
Based on my squinting at the tea leaves, DG is apparently a more attractive investment over the next 3 years.
But I am very much more sure of my opinions about the value of Berkshire than I am about DG, so I have a much bigger BRK position, and I'm not about to reverse them.

If you had a lot of investments that you were equally sure about, I think adjusting them based on relative forward returns would make a lot of sense.
Sometimes when I have two fairly similar investments I have a gander at the ratio of their prices.
Stockcharts.com has the stock price ratio feature, for example two dollar stores: https://stockcharts.com/h-sc/ui?s=DLTR%3ADG&p=D&yr...
This makes it very clear that dollar Tree has done way better than DG recently.
When that sort of graph swings a lot to the high or low side, it's not a bad time to shift money from one to the other.
You don't have to pick a peak or trough--moving back and forth will increase your long run returns provided you alternate the direction of your movement.
But for me it's relatively rare to have two positions that I am equally sure about and fulfil similar functions within the portfolio.
And it's hard to see where cash fits into the formula.

The main reason that sitting on your hands is usually the right decision is that most investment decisions (including mine) are mostly based on forecasts of future outcomes that are much worse quality than we think they are.

Jim

No rebalancing at all also seems nonsensical because the whole point is to buy more when something is supposedly cheap. If it's price rises it gets less cheap if everything else is unchanged so at some point there should be some rebalancing by selling something not that cheap anymore for something else that's supposedly cheaper now. But when to rebalance? How often?

Great question. Mechanical investing has mechanical answers, of course -- once a year, once a quarter, whatever the backtested formula prescribes. But your question can also be viewed through the lens of the earlier thread about QQQ vs. QQQE.

Relying on JohnIII's reporting, QQQ, which mimics the Naz 100 index by letting its winners run and seldom rebalancing, has outperformed QQQE, the version that rebalances continuously to maintain equal weights of the constituents, by more than 2% per year since QQQE's inception in 2012, a significant margin that translates to cumulative returns of 457% for QQQ and 294% for QQQE.

The key components driving this outperformance are the Magnificent Seven. At a rough approximation, Nvidia is up 135x over that span; Tesla, 123x; Amazon, 11x; Microsoft, 10.5x; Meta, 10x; Apple, 9x; Alphabet, 8x. QQQ has benefited from all of that. As a result, those seven holdings have grown to represent more than half of the market-weighted index. By contrast, of course, they represent ~7% of the equal-weight QQQE, resulting in its underperformance over that 11-year period.

Most if not all of the Magnificent Seven have reached multiples along the way that would have tempted traditional value investors to sell. Yet riding these winners has worked out much better than rebalancing -- so far. It's also worth noting that with respect to Apple, Mr. Buffett has allowed his winner to run to an outsized percentage of Berkshire's equity portfolio.

As Jim points out, we all have a tendency to overestimate our ability to project a company's future performance. What rebalancing within a fixed set of securities like the Naz 100 seems to presuppose is that they are of relatively equal quality, so if market sentiment drives up the price of any one component, better to take the profit and rebalance than ride it back down.

But the components of the Naz 100 are clearly not equal. The Magnificent Seven have dominated in their respective markets, driving extraordinary returns. Selling them off along the way to keep their percentages of the fund small does not, in retrospect, seem like the wisest course.

Interestingly, the Naz 100 is market-weighted with modifications intended to avoid "overconcentration." It announced Monday it would rebalance later this month to reduce the percentages of its largest holdings. (This accounts for the anomalous one-day performance Monday that JohnIII reported.) The five biggest components -- Apple, Microsoft, Google, Amazon and Nvidia -- will be reduced from a combined weight of 46.7% to 38.5%. So the Magnificent Seven will still represent an outsized share of the 100-stock index, just not quite as outsized as they do now.

The criteria for selection of the Naz 100 components is different from your criteria, of course. The former were not selected for their perceived "cheapness." So you may find this analogy irrelevant. But your question crystallized for me the tension between a value sensibility and the historical benefits of letting your winners run.

How to handle this in practice?

No rebalancing at all also seems nonsensical because the whole point is to buy more when something is supposedly cheap. If it's price rises it gets less cheap if everything else is unchanged so at some point there should be some rebalancing by selling something not that cheap anymore for something else that's supposedly cheaper now. But when to rebalance? How often?


I like this line of reasoning and like to think I do something similar, and of course it is also quite close to the rebalancing that Manlobbi recommends, investing more heavily in stocks that have a higher multiple to the minimal plausible (plausible in your opinion) intrinsic value in 10 years. https://discussion.fool.com/t/welcome-revisited/78...

Of course you have better things to do than rebalance by a tiny amount each day, even if transaction costs and tax costs were minimal. But if you DID do that, it wouldn't matter - yes, you would be selling tiny slivers of your holdings in something that had gone up one day, and presumably buying them all back when the share price came back down. But it would give you very similar results. If you wanted to convince yourself of this, try setting up a spreadsheet for a stock that is trading, say, at 5 times your assessment of the IV in 10 years, and which you would sell entirely if it were to go down to 3 times. Now compare 2 strategies, where in one of them you sell 5% every time the Price:IV10 goes down by 5% of the distance between 5 and 3, i.e. by 0.1, from 5.0 to 4.9 for example, and from 4.9 to 4.8. And for the other strategy, you sell 20% every time the Price:IV10 goes down 20% from 5, i.e. only at 4.6, 4.2, etc. from its original value. I've not yet succeeded in getting Excel to simulate this for me, but I'm pretty sure both strategies will give me the same gain. The more active one will register smaller gains often; the less active one will register big gains less frequently.

For instance, going from a Price:IV10 of 5 to 4, the active strategy will give me a small gain at 4.9 (as the price is higher), another small gain at 4.8, again at 4.7, etc.. Once it gets to 4.6, it is true that you would have obtained a larger gain by waiting, getting the full benefit of that price change instead of only most of it. But the price may not go down directly to 4.6, either; it may bounce from 4.8 back up to 5.0, then to 5.3, then back to 4.9, then back to 5.1, ... Here, the fine-toothed strategy is giving you little gains all the time, which I expect will fully compensate you for the fact that you have been reducing your stake a bit after the small price gains.

There's probably a mathematical way of proving (or, I suppose, disproving) this, but I can't think of it right now. That's not to say that it is a good idea to be making all these little transactions with small price movements; you are mostly wasting time and effort. I'm just saying that it shouldn't actually hurt your performance.

dtb

The problem my approach causes in the end is exactly what ultimatespinach described beautifully with these words:

the tension between a value sensibility and the historical benefits of letting your winners run.

Up to now the big winner of those 10 stocks by a wide margin is META --- and I couldn't resist selling the calls I bought when they were up 150% or so, keeping only the shares I also bought. META's run was so huge that even after selling all those META calls it's still overweight and this strategy says "Sell a good part of the META stock and buy Verizon instead".

That huge run brought me to think like you what would happen if in extremis rebalancing is done daily, whether it wouldn't have ruined those profits completely. You may be right with:

Of course you have better things to do than rebalance by a tiny amount each day..... But if you DID do that, it wouldn't matter - yes, you would be selling tiny slivers of your holdings in something that had gone up one day.....

Right because it really is about, yes, "tiny slivers" only, and next day or week again a tiny sliver only, then with a little more profit.

Still not sure, though. Especially not because in this current case it would have been since months now about constantly selling each day those tiny slivers of META for Verizon - and up to now that clearly would have been wrong compared to the "sitting on my ass" I did instead.

Maybe only time will tell, looking in hindsight in 1-2 years how META and Verizon did and what the outcome of constant rebalancing would have been. Unfortunately even then it's not an absolute verdict of what's better, rebalancing regularly or letting the winners run, as it's all based on something highly subjective, on perceived/assumed relative "cheapness".

But definitely the whole theme is about what ultimatespinach described, constant rebalancing according to perceived(!) valuation or "letting your winners" run. Surely there must be numerous studies --- with a definite answer to this question?

Rebalance between asset classes, not individual securities.

Past price movements of a stock have NOTHING to do with future price movements (in the long term). This is both 100% true and very hard to grasp.

Price increase or even P/E increase by itself signals nothing (I mean in terms of future price). You just have to buckle down and project future growth. There is no shortcut or mechanical formula.

"Surely there must be numerous studies --- with a definite answer to this question?"


Undoubtedly, but there is no getting around the fact, as a smart fellow (whose name escapes me) said, that the key problem in investing is that all of our information is about the past, and all of our decisions are about the future.

there is no getting around the fact, as a smart fellow (whose name escapes me) said, that the key problem in investing is that all of our information is about the past, and all of our decisions are about the future.

It may be the key problem, but it is a problem that extends to life in general. Rejecting well-reasoned arguments based on past experience, simply on the grounds that future experience may be different, is to reject the possibility of argument as such.

As another smart fellow, whose name was Aeschylus, said, "All wisdom begins with memory."

Baltassar

"It may be the key problem, but it is a problem that extends to life in general. Rejecting well-reasoned arguments based on past experience, simply on the grounds that future experience may be different, is to reject the possibility of argument as such.

As another smart fellow, whose name was Aeschylus, said, "All wisdom begins with memory."

Baltassar


Agree completely. Not rejecting anything. I move forward sanguinely, rationally, humbly, searching for value, based on the best available information, gleaned from how things have worked out many times in the past, while stopping short of utter certainty that I'm right. That, as Shakespeare said, is cruising for a bruising.

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