By John Reese (@guruinvestor) —
Deciding what stocks to buy and when to buy them is a question that can plague investors. But deciding if and when to sell can be equally if not more daunting. After all, you don’t want to leave money on the table by getting out too soon. On the other hand, if you wait in the hopes that there’s more upside, you run the risk of quite literally leaving money on the table if the stock dips.
Evaluating the best time to sell can also be a layered process for the individual investor if they have invested emotion into the stock—that is, you might not want to “give up” on a stock that has made money for you in the past, even if the underlying business has lost its competitive edge. Or you might resist selling a stock, even if it’s a clear loser, because you don’t want to admit failure. Humans are complex beings, after all, with an infinite menu of possible emotions around the buy/sell decision.
When I started building model portfolios in 2003, I wanted to create ways to overcome the subjective challenges around buying and selling by following strategies that are quantitative and focus on fundamental criteria. To do this, we codified a portfolio management process that was set to be updated on fixed-interval rebalancing time periods. Using stock screening models inspired by some of the most successful investors, we are able to identify which stocks achieve high scores based on their underlying fundamentals and which have slipped. On rebalancing dates, we then use this information to determine which names to keep and which to sell, replacing the sold shares with higher-scoring names. Such a system keeps emotions out of the process—a crucial advantage to every investor—by sticking to concrete metrics and buying/selling only at predetermined intervals.
The question then becomes: What should the rebalancing intervals be—monthly, quarterly, annually or some other frequency? That depends on your investing strategy and what the underlying data shows. One of the guru-inspired portfolios I track, for instance, which is based on the philosophy of Stanford University accounting professor Joseph Piotroski, behaves very differently depending on the rebalancing period used. For example, while a 20-stock, monthly rebalanced U.S. portfolio assembled using this model reflects underperformance (over the period since its inception in 2004) compared to the S&P 500, the same portfolio rebalanced annually outperforms the market. View the Book/Market investor portfolios based on Piotroski’s method here.
The opposite happens when using another of my guru-inspired approaches–one based on the strategy of Motley Fool co-creators Tom and David Gardner. This portfolio reflects very different results when using different intervals (returns calculated over period since inception in 2003). If rebalanced annually, for example, it underperforms the market by 37%. If quarterly and monthly rebalancing is used, the portfolio outperforms the S&P 500 by 60% and 222%, respectively. View the Small-Cap Growth investor portfolios based on The Motley Fool model here.
Why do these two different strategies react so differently to changes in rebalancing periods?
It ties back to the focus of each strategy. The Piotroski-inspired strategy, for example, is a deep value approach that targets stocks with book-to-market ratios (the opposite of the price-to-book ratio) in the bottom 20% of the market along with other factors that demonstrate a solid underlying business. These stocks are unloved, beaten down, and in need of an investor with the patience to wait until the market recognizes their value. It makes sense, then, that a longer rebalancing period would pay off, since it gives the market time to catch up, so to speak.
The Fool-inspired strategy, on the other hand, is focused on growth and momentum, and looks for companies with sales and earnings growth of at least 25% in the most recent quarter. This approach also targets companies whose shares have been outperforming at least 90 percent of other stocks in the market over the past year. With these types of “hot” stocks, however, comes the risk of a dramatic downturn. It stands to reason, then, that a shorter rebalancing period works better for this type of portfolio.
What are the primary takeaways here? Including a set rebalancing process into your investment approach can help remove emotion and biases that can negatively impact returns, but that doesn’t necessarily mean this will work well for everyone. Rebalancing also requires that you monitor and update your portfolio, which could trigger emotional reactions and, potentially, buy/sell decisions that may be ill-advised. But if you’re an investor who likes to use stock screens and quantitative methodologies, it’s important to have a rebalancing system in place.
John Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. Validea is a quantitative investment research firm and Validea Capital, a separate company from Validea.com, which maintains this blog, is a asset management firm offering private account management, ETFs and a robo advisor, Validea Legends and Validea Legends Income. John is a graduate of MIT and Harvard Business school, holder of two US patents and author of the book, “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Follow John on Twitter @guruinvestor.