Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: And also, reminder we are running our competition. So, we’re asking people to go into their podcast app and leave a comment. And then email that to my email address which is in the show notes. And we’re giving away – how many? 5?

Jayamanne: 5.

LaMonica: 5 Amazon Echoes.

Jayamanne: So very good chance of getting one if you do this.

LaMonica: Exactly, exactly. So it is a good deal. And we were recently giving way other things. We went to a conference together – Morningstar sponsored – was one of the sponsors of the conference.

Jayamanne: The ASA conference. You did a great job. You did a presentation on debt.

LaMonica: I did and so that’s the Australia Shareholders Association and then when I wasn’t presenting…

Jayamanne: I was feeling a little starstruck because...

LaMonica: Starstruck?

Jayamanne: Yeah, it’s, it’s very hard to be in you presence Mark because you have a lot of fans.

LaMonica: I would say that a lot of podcast fans came over to our booth which was very nice.

Jayamanne: But they did take photos of you.

LaMonica: Well, one guy took a selfie with me. And then this other strange man took about 45 photos of me. And I asked him, “Would you like me to just stop talking to other people so you can take a picture?” and he just said, “No, keep going” and kept taking these pictures, so somewhere there’s 45 pictures of me with my mouth open, on some random old man’s phone.

Jayamanne: Well, there you go.

LaMonica: Yeah exactly. So, speaking of fans of the podcast, today we are going to do another listener submitted question. And the question is around rebalancing and it’s from Kim. So, Shani, why don’t you walk through the question we got? 

Jayamanne: Alright so, Kim mentioned that we’ve had episodes on portfolio construction, picking stocks and retirement but we haven’t discussed rebalancing yet. Kim mentioned that it would be a good topic to cover given the period of volatility we’ve gone through where we’ve seen varying performance from different sectors. 

LaMonica: And Kim also included a Warren Buffett quote – and I figure this is probably an attempt to just get us to drink Shani.

Jayamanne: We don’t need much encouragement to be honest.

LaMonica: Yeah, and it, and it worked. But the quote Kim mentioned was a good one and is “The weeds wither away in significance as the flowers bloom.” 

Jayamanne: And the quote is referencing how in Buffett’s portfolio he has bought many shares over the years but his portfolio is dominated by the huge winners he has found. And that is a good place to start talking about rebalancing. 

LaMonica: So let’s start with some share market facts and then we can talk about how that quote and rebalancing relates to your portfolio. The first fact is that overall market returns are driven by a surprisingly small amount of companies. 

Jayamanne: There was a study put out in 2018 by Hendrick Bessembinder that explored this very topic. 

LaMonica: And that’s a great name right – Hendrick Bessembinder. And so, he is a professor at Arizona State University. And for those that don’t know, which I assume are most of the Australian listeners, Arizona State University is known as one of the top party schools in the US. So if you go there Shani, you can party with Hendrick Bessembinder.

Jayamanne: Was this not one of your criteria for university?

LaMonica: I was just, I just went to any school that would let me in.

Jayamanne: That accepted you? Okay.

LaMonica: Although funny thing. The uni that I went to, the year that I went there it was named the number 5 party school in America by Playboy.

Jayamanne: Hard to know what to say to that. Okay well in between all the partying he managed to put out this study that looked at return data in the US between 1926 and 2016 and found that the top performing 1,092 listed US companies which is 4.31% of all listed stocks during that time period accounted for all the wealth creation from investing. 

LaMonica: And he defined wealth creation as returns that exceeded US treasury bills. So that’s a very short-term fixed interest investment. And then when he replicated the study in 42 global markets and found that between 1990 to 2018 the best performing 811 companies or 1.33% of the total accounted for all the net global wealth creation. 

Jayamanne: And this is why Buffett talks about letting your winners run. Because once you have those winners in your portfolio they can drive a disproportionate amount of your returns. 

LaMonica: And one more market fact. So there was this interesting article in Firstlinks from Ashley Owen that looked at ASX listed companies. So he found that of the 37,000 companies that have ever been listed on exchanges in Australia, 33,500 of them have been delisted. Which basically means they were worthless. 1200 companies were bought by other companies and then of course 2,300 companies remained in 2019 when the study was done. 

Jayamanne: So there are lots of losers.  

LaMonica: Yes, thank you for looking at me while you said that Shani. So these two studies are an indication of where Buffett came up with that quote. I guess at the end of the day right Shani, there is no point in rebalancing. You just have to find the winners and let them run.

Jayamanne: But obviously we are going to provide some context and detail around rebalancing. Rebalancing is the act of adjusting your portfolio when the composition changes due to relative outperformance of certain asset classes. 

LaMonica: Which naturally means selling relative winners and buying relative losers in your portfolio. Which on the surface seems to be the exact opposite of what Buffett is saying. But the devil of course is in the details. 

Jayamanne: Part of the confusion about rebalancing is what level does it happen. For instance that Buffett quote is about individual holdings in portfolios but we can start this rebalancing conversation at the asset class level and work our way down. 

LaMonica: And as a reminder different asset classes have different expected returns and are subjected to different levels of volatility. Shares have high expected long-term returns and can bounce around in price a good deal in the short-term. At the other end of the spectrum cash has very low expected long-term returns but no short-term volatility.  

Jayamanne: And that is why asset allocation decisions have such a profound influence on the returns of your portfolio. And once again this is an extreme example but a portfolio with 100% cash is never going to get the same return over the long-term as a portfolio that is 100% invested in shares. 

LaMonica: And investors generally don’t go to those extremes that Shani just described and portfolios will have a mix of growth assets like listed property, shares and infrastructure and defensive assets like bonds and cash. And we want to select an appropriate asset allocation that will give us a reasonable chance of getting the return needed to achieve our goals. 

Jayamanne: That is the process that we outlined in our portfolio construction episode. And that is what we want to do when setting up our investment strategy. You may decide that 90% of your portfolio needs to be in growth assets given the return you need. But that asset allocation will of course change over time because prices are constantly changing.  

LaMonica: And this may seem trivial but let’s say you are aiming for a portfolio that is 60 percent shares and 40 percent bonds. If bonds go up 5% in a year and shares go down 20% which is not an unprecedented occurrence your asset allocation will change. Now 47% of your portfolio will be in bonds and 53% in shares. 

Jayamanne: And this will change your return profile over time. Our long-term estimated returns for Aussie shares are 7.90% a year and for Aussie bonds it is 2% a year. That original 60/40 asset allocation had an expected return for the portfolio of a little more than 5.5%. The new allocation has expected returns of 5.1% a year. 

LaMonica: And that can make a difference over many years. But that is also just the hypothetical returns from a single year. If you never make any changes to your portfolio it can start to look even more different than your target. 

Jayamanne: And this is one way we need to think about rebalancing. Ensuring that your asset allocation is still aligned with your goals. And we will get into some practical ways to do this later on but lets talk about individual securities. That is where that Buffett quote comes in and all the stats about what drives investment returns. 

LaMonica: And just as the value of different asset classes change in your portfolio the values of the individual holdings within those asset classes changes. And I want to be perfectly clear that I do not consider this rebalancing. In my opinion rebalancing occurs at the asset class level and when we look at single positions what we are really talking about is diversification. 

Jayamanne: And this is an important distinction. Because many investors confuse these two notions. Now in some cases if you are a passive investor you may only hold a few index ETFs in your portfolio. In that case the single security and the asset class are the exact same thing. But when we talk about holdings level decisions we are thinking of an example where within your equity allocation you may hold 4 ETFs and 20 individual shares. 

LaMonica: And while asset allocation is about expected returns of your portfolio and your ability to achieve your goals, diversification is about mitigating risk. Specifically it is about mitigating single security risk. We diversify away single security risk by increasing the number of holdings we have. 

Jayamanne: And we do this because we don’t want one of our holdings to have the same fate as those 33,500 and become worthless and have that torpedo our chances of achieving our goals. If that holding makes up 25% of our portfolio we will likely have a hard time making up for that. If it is 3% of our portfolio that is likely a survivable event. 

LaMonica: And for people that haven’t been investing for a long time and are investing in individual shares I am here to tell you that at some point this will happen. If you are investing in more speculative shares it is probably going to happen more frequently.  

Jayamanne: And this of course is the benefit of investing in something like an ETF. Because an individual holding can become worthless but that is not going to happen with a broad index. So while it may drop 20% or more in a year it isn’t going to go down 100%.  

LaMonica: Now there may be cases when a single holding in your portfolio does very well. And it could grow to make up a larger and larger position in your portfolio. And you will have to make a judgement call whether you think you are introducing yourself to too much single security risk.  

Jayamanne: And there is no perfect formula here to how much of a portfolio is too much. But a good thing to consider is what would happen if a single stock holding does go to zero. What would this do to your ability to achieve your goals? And this may vary with how long your investment time horizon is and what non-portfolio resources you have if you are not taking a holistic view of all your assets.  

LaMonica: It also matters in what you are investing in. Larger companies that are profitable in boring businesses and pay dividends and have strong finances are less likely to go out of business than a speculative miner. So consider that as well to make a decision. I personally don’t want a single share position to make up more than 5% of my portfolio but that is just me and based on my personal circumstances. I’ve heard from a lot of investors that are very uncomfortable with a single share holding getting larger than that. 

Jayamanne: And of course if that holding is a well diversified ETF or Fund you should be much more comfortable with holding sizes significantly exceeding that level to the point where a single holding could make up your entire allocation to specific asset class. 

LaMonica: Let’s talk a bit about the act of rebalancing now that we have dispensed with the theory and try and provide some practical tips. This would also apply to diversifying out of large positions. There are two theories around rebalancing. The first is that you pick a set interval – annually perhaps – and look at your portfolio and get it back aligned from an asset allocation perspective. 

Jayamanne: The second theory is that you instead use tolerances. So you may set a 10% tolerance which means that if your goal is to have 60% allocation to equities and it gets to be more than 66% you would rebalance. And in both these cases – an interval like a year or a tolerance, you are trying not to do it too often as your portfolio will naturally fluctuate.  

LaMonica: And the reason that you don’t want to do it too often is because rebalancing has a down side. There are transaction costs and there are likely taxes as you sell things that have gone up in value. 

Jayamanne: How do you think about rebalancing given those downsides? 

LaMonica: Well this doesn’t just have to do with rebalancing but my default investment approach is to never sell anything. Now obviously I still sell things from time to time. But as a young investors I studied the market for a bit and quickly realised that our worst enemy as an investor is ourselves. People trade way too much – both individuals and professionals. We overestimate our ability to be nimble and respond to market events and continue to convince ourselves that our next idea is the best one ever. And this leads to terrible outcomes. We sell things that go up more than what we buy as we’ve seen through countless studies, we pay more in taxes and we pay more in transaction fees. That is why investor returns are constantly below investment returns. So I’ve set my default as never selling to create a really high hurdle rate to protect myself from poor behaviour. And that is why I hope that I have a behavioural edge over other investors.     

Jayamanne: So does this default of never selling mean you don’t believe in rebalancing? 

LaMonica: Not at all. But selling something is a last resort for me. I think that asset allocation is a key to driving my long-term returns. But I look for ways to reallocate without actually selling anything. I am still saving money into my investment accounts. So that is one way I can reallocate. I can simply redirect those new contributions into an asset class that is below where I want it. Also, I am an income investor so I can use that income to also invest in asset classes that are below the allocation that I want. That has no consequence to my taxes as I will owe them on a dividend if is reinvested or not. What about you Shani? 

Jayamanne: I’m at a stage in my life where I have very long time horizons to reach my goals. And having a long time horizon means that the majority of my portfolio is in aggressive assets. And these aggressive assets, they sit in ETFs and funds, for the most part, and the underlying assets are rebalanced, but I just have not found a need to sell out of my investments to bring my investments back to a certain range. My main focus is just pumping as much savings as possible into these assets while I am young – and I’m on the same page as Mark – I don’t find the need to sell. I have had to build up a bit more of a cash buffer to build up an emergency fund. And I have enough cashflow coming in to be able to redirect investments to cash or defensive assets, instead of selling out of investments to rebalance. 

LaMonica: Okay so I had a thought Shani, while you were saying that. And just wanted to add one more thing. So my portfolio – I have growth assets of course like shares, and then defensive assets. But for defensive assets I put everything into cash and term deposits. And there is a reason for this and I’ll get to the rebalancing reason for it in a second. But On May 23rd the Aussie 10 year government bond is yielding 3.61%. And ING - which is the bank I use for cash savings –  is offering a 210 day term deposit for 4.5%. And that is also guaranteed by the Aussie government, at least for the amount I am putting in there. And so personally I just don’t see a reason to buy a bond especially given the flexibility that cash offers which I’m a big fan of. Now I know that I face the risk that interest rates go down and I can’t secure that rate on the term deposit for longer than 210 days. But it is very difficult to buy an individual bond in Australia which means purchasing through an ETF index fund or an active manager – and both have a lot of downsides. And the first is that of course I have to pay a fee to do that and there are transaction costs. And the second is the risk and return profile of a portfolio of bonds purchased through an ETF or fund is very different than buying an individual bond where I know I will get my money back at maturity as long as the issuer doesn’t default. So that ETF or fund could face a capital loss if interest rates rise or the shape of the yield curve changes. And to me that it’s just not worth it. And so holding cash makes it a lot easier for me to rebalance. Especially since I still have a long-time horizon and most of my portfolio is in growth assets. 

Jayamanne: That was bordering on a rant.

LaMonica: Bordering on a rant?

Jayamanne: Yeah.

LaMonica: Okay. I’ll take that. That’s not too bad. But yeah, I guess to reiterate – maybe make it into a rant, maybe cross the border. I would just rather hold more cash. And I think it just gives me flexibility and increased safety than a bond, ETF or fund. And that’s what allows me to sleep at night, even though I don’t do that very often, and I think it’s really the best way to go about achieving my goal. So even if I know that the return on cash has barely exceeded inflation over the long-term it still has a lot of value to me.

Jayamanne: What about the second scenario of having a single position become larger than an investor is comfortable with?  

LaMonica: Yeah sure, well I think it’s the same techniques that we described earlier. So, if there’s a single share in my portfolio and it gets larger than I want, I will turn off the dividend reinvestment and direct that income into different investments. And kind of the last thing I would say is that in light of that Buffett’s quote, is you know, letting your winners run, is something you can do if you are comfortable using cash to offset these concentration risks in your portfolio. So, I certainly don’t want a single security to get more than 5% or a single individual share holding to exceed 5% of my portfolio but I do think that I can get that percentage down over time in a more tax efficient way than simply selling. So remember that even with the long-term 50% capital gains discount you are taking a big hit depending upon your tax bracket if you do sell an appreciated holding. Alright rant over. And podcast over.

Jayamanne: Podcast over.

LaMonica: But remember. Leave us a comment. Send it in to my email address and you could be a proud owner of an Amazon Echo Dot just like Shani is.