Essay

I have always felt that individual investors (or perhaps any investor to some extent for that matter) have never got a complete handle of the decision on when to sell. Traders or speculators mostly have a fixed target for profit or stop-loss, but investors never seem to enter a stock with a clear exit goal.

Rebalancing as a strategy might provide answers to solve this quandary – more than anything else for the individual investor. At a portfolio level, it provides you with a clear answer on when to sell, and, if required, it can be translated and implemented at an individual stock level also by more mature individual investors. Setting asset allocation limits at various levels in a portfolio can provide you with clear triggers on when to sell. So then, you stop asking yourself questions like – should I sell stock A at this price or wait for some time – questions which have no clear answers anyway. On the other hand, that answer is provided at an overall portfolio level, based on allocation limits.

For example, to provide a complex set of rebalancing rules, consider the following: If you determine that equity will account for 60% of my portfolio, and within that, large cap stocks will account for 50% of the holdings, and then no industry will account for more than 25% and no stock more than 10%, then it becomes easier to take decisions on what and how much to sell when these allocation percentages go out of whack. And if you are not a direct stock investor, but take your exposure through mutual funds, it gets much easier than the above scenario, assuming that your fund manager is dealing with the rest. Therefore, ‘I bought stock A at X, should I sell it now at this price Y’ becomes a wrong and somewhat irrelevant question, and thankfully so.

Of course, rebalancing is not a strategy that guarantees the highest returns. In certain cases, you may end up selling your winners, which in hindsight may not feel great. But for individual investors, who may have no particular reason to feel a sense of conviction about a specific stock, it provides a good way to reduce or manage risk. I do not think at a mathematical level, rebalancing has a very high impact on returns, but it sure reduces risk of excessive falls and locks in some of the profits. And if done correctly, it will also ensure that you buy equity at a time when every one is running away from it – in which case rebalancing affects your long term returns too.

An important effect of this strategy might well also be at a mental or psychological level – because an individual investor feels he is in control and has been smart to book profits when his portfolio grows and to buy stocks when they were low in price.

Therefore, less for returns, more for managing risk, and most importantly for the psychological advantage of getting emotion out of buy/sell decisions, rebalancing is a crucial strategy for portfolio management for individual investors.

The core objective of diversification is to reduce risk. The idea is that peaks and troughs in a specific investment should not affect overall portfolio return objectives.

One must define risk less as volatility, and more as a either a complete or partial, but permanent loss of capital. In that case. an individual investor would be well-advised to consider diversification to reduce risk of a few primary types:

Asset Market or Systematic Risk

What if I am invested in the wrong asset class or market? This is best reduced by a prudent asset allocation decision. Investors should identify different types of asset classes that they want to be invested in. Along with that, they must define ideal target percentages in each asset class. This will minimize the impact of being invested in the wrong asset class.

Unsystematic Risk

What if I choose the wrong stock or bond or property? Investors can reduce this by investing in a pool of candidates within the same asset class. So if it is equities, it is best to be invested in a bucket of unrelated good businesses, or in commodities or real estate, again try and be invested in unrelated asset candidates. This will minimize the impact of being invested in the wrong securities.

Timing risk

What if I invest at the wrong time? You may have a well-diversified pool of securities in a well adjusted portfolio of asset types, but what if you invest at the peak of the markets? This is best reduced by making periodic investments in the assets of your choice, so that timing risk is reduced. This will minimize the impact of being invested in any asset at purely the wrong time.

For individual investors, more than chasing returns, if prudence is exercised in constructing a portfolio with the objective of reducing risk of the above three types, there are good chances that the returns will take care of themselves.

At the heart of any investment strategy is a key decision that the investor needs to make right at the start. This decision could change based on life circumstances and priorities (hopefully not based on swinging moods). But once made, it is important for investors to stick to that. And that decision is what type of investor should you be?

I mention this as a decision that the investor must make, because a lot of current advise seems to try and answer the question – what type of investor are you? rather than what type of investor should you be? The former, I think, is a wrong question to ask – likely to end with the right answers to the wrong question. Very often, in response to this wrong question, investors will end up with the right answers that provide characteristics like aggressive, moderate and risk-averse, derived on a questionnaire around mental make-up, age, income level, etc. Whereas, if one shifts the onus on the decision to be made by the investor – on what type of investor should I be – the next question that comes up will be – how should I decide that? Now that’s a good question to ask.

Basis for the Key Decision

The answer to that is provided by legendary value investor Benjamin Graham in his investment classic  “The Intelligent Investor”.  That decision should be taken based on a simple criteria: Am I willing to put in more effort for more returns? If that is the case, I would be an aggressive (or enterprising) investor. If that is not the case, I would be a defensive investor, and should be happy with lower returns.

Very simple – like all other things in life. If you are willing to work for it, you deserve higher returns, else be happy with lower returns.

This may seem like a simple decision to make – but is not easy to stick to. A lot of investors end up trying to be both, and often with bad results. As Graham says, there is nothing like a part-time enterprising investor, because one does not know what one doesn’t know, till experience teaches it. But that is a discussion for another day.

The key is – to take this decision on what type of investor you should be, and sticking to it. Your circumstances may change in which case you may make a conscious decision to change your type. But it should be like a switch – on or off. This decision will have a bearing on the kind of portfolio that should be cultivated. Anything in between may provide excitement, but may not provide investment results.