Let Your Best Investments Run
It’s now late December and the year 2017 is drawing to a close. For the stock market it’s been a pretty incredible year — the S&P 500 has returned 18.76%, and the Dow has returned 24.51%.
It’s years like this when many investor thoughts turn to harvesting those gains, and rebalancing portfolios into neat orderly asset allocations.
Some investors believe rebalancing every year is a good way to control risk. Imagine you started the year with an initial portfolio of 60% stocks and 40% bonds. This asset allocation then drifts over the year to 65% stocks and 35% bonds. This higher stock allocation is said to be “riskier” due to its larger allocation to volatile stocks that could go down next year.
A rebalancing investor would sell that excess 5% in stocks and then purchase bonds to “rebalance”, thus bringing his or her portfolio back to his preferred model of mathematical perfection.
Unfortunately most experts agree that portfolio rebalancing does not (on average) lead to superior returns. It’s simply a way to control Beta (Risk) as defined by the CAPM (Capital Asset Pricing Model).
How Do You Define Risk?
In simple terms, CAPM defines risk as an asset’s volatility relative to the overall market. If a stock’s price wiggles around more than the market, it’s considered riskier than a stock who’s price wiggles around less than the market.
That’s great in theory, but the rest of us live in the real world. Not some model of mathematical perfection.
I think Seth Klarman summed up the problems with beta nicely when he said the following,
“I find it preposterous that a single number reflecting past price fluctuations could be thought to completely describe the risk in a security. Beta views risk solely from the perspective of market prices, failing to take into consideration specific business fundamentals or economic developments. The price level is also ignored, as if IBM selling at 50 dollars per share would not be a lower-risk investment than the same IBM at 100 dollars per share”
In the real world, risk has very little to do with a stock’s price movement and everything to do with a business’s fundamental condition — How much debt does the company have? How much cash is on hand? Is the business profitable? Are sales increasing or decreasing?
Ask any small business owner about risk — They can give you a full doctoral thesis on real world risk, and not a single one of them will mention beta.
Unfortunately there’s no simple formula for computing this “real world” risk. There’s thousands of possible variables.
This is where investing quickly becomes more art than science.
Managing Risk
How I manage risk in my portfolio is a little different than standard portfolio rebalancing theory.
Imagine for a moment that you’re the coach of a small town sports team. You hold “tryouts” every year for new players, set a practice regimen, and decide who’s going to play in the team’s games.
Ultimately you want your team to win games, and you do that by picking the best players. The best players get the most “game time”, while poor players ride out the season on the bench.
Now let’s also say that your team had a great season and went on to win the state championship. When next season rolls around and you get a fresh set of players, do you suddenly dump the veterans to maintain a proper “allocation model”?
No, of course not! However, the answer is filled with surprising nuance — For one, last season could have been a complete fluke. Some of your “players” could have just had a lucky season, and they might lack the talent to repeat a championship win.
For two, a few of those new kids could have considerable talent to be realized… if they’re given the chance to play.
Managing a portfolio of investments isn’t all that different from managing a sports team — Instead of “players” we have stocks, bonds, REITs, and other assets that “play” on our “team”. Our “season” is the calendar year, and “winning” can be whatever yardstick you choose to measure investment performance against.
As the “Coach” of your portfolio, you want to select the best performers year after year. Some investments will be duds, and others will be real gems.
When you finally stumble upon a gem you’ll know it — year after year that investment performs incredibly. Ultimately you want to keep this winning gem on your “team”. Maybe you even double-down on this winner.
Simply put, you ride that horse as long as it’ll keep winning.
I’ve been lucky enough to stumble upon a few of these gems over the years — good companies bought at the good prices that gave me ridiculous returns. I’ve shared a few of these winning gems with readers of this blog too — Montpelier RE, L Brands, and Mid America Apartment Communities.
Some of these stocks I’ve continued to hold for over a decade now, while others like Montpelier were purchased by a larger companies. I’ve realized incredible gains simply because I saw fit to hold these winning investments.
Today I’d like to share a different kind of investing gem — one I haven’t talked about before. It’s a REIT called First Industrial Realty Trust Inc (stock symbol: FR) . The name is a mouthful, but the performance since I purchased shares has been nothing short of spectacular.
The company’s business is renting industrial real estate (aka warehouses). This is their main business, but they also have a side business constructing “Build-To-Suit” warehouses for large clients. Back in 2008, this “Build-To-Suit” business contributed a significant portion of earnings.
I first purchased 300 shares of FR back in October 2008 for $8.15 a share. The market had beaten down share prices to single digit price levels.
Unfortunately that warehouse construction side business came to an end in late 2008/early 2009 — because absolutely nobody was building new warehouses. On the rental side, warehouse vacancies skyrocketed. Truly, it looked like the REIT was in bad shape. The stock price tanked as a result.
I purchased shares again in March of 2009 for $2.92 per share. This time it was 2000 shares, bringing my average purchase price to $3.60 per share.
The actual “How” and “Why” I chose to quadruple-down like this are the subject of another post. Today I just want to emphasize this concept of holding onto “winners” and letting them continue to win.
Take a look at the performance I’ve realized since investing in March 2009:
Now, did I sell when the shares doubled? How about tripled? Maybe when they quadrupled? Nope, I simply rode that investment to a nearly 900% return.
I didn’t “rebalance” when FR became a larger chunk of my portfolio. I stuck with it. Had I sold at the first signs of a good profit, I wouldn’t have realized returns anywhere close to that.
Today, those shares don’t produce the same dividends as they did before the Great Recession, but the shares have recovered and I’m realizing dividends of $0.84 per share. That’s 23% of my initial purchase price in dividends every single year.
When To Bench
The trick of course is knowing when to send one of your players to the bench. How do you know when an investment has petered-out and the returns won’t continue?
You need to understand that investment really well.
In the case of FR, it’s merely an average business. I purchased those shares at a disgustingly cheap price, and simply rode the economic recovery to the high point we’re at today. If this is the “economic peak” then perhaps now is a good time to sell.
At some point, the economy will head into recession again and FR’s share price will crater once again. If I knew exactly when shares would drop, the smart move would be to sell at the top and then repurchase at rock bottom prices.
Unfortunately I can’t predict future stock prices.
As this example shows, an average business purchased at incredibly cheap prices can lead to incredible returns over long periods of time. But this is a rare event.
Rather than trying to repeat this trick year after year, I try to focus my efforts on finding truly great investments selling at reasonable prices. The ones you stick with year-after-year because your performance isn’t achieved by purchasing at disgustingly cheap prices.
Sure I’ll take bargains like FR, but I want the investments that do OK in a bad economy and do even better in a good economy. These are the Moody’s and Apple’s of the world — exceptional companies that rarely get cheap.
In either case, my advice is to simply let your perennial winners run.
Wow, nice score on that FR REIT. I don’t invest in any individual stocks. I just don’t have the time or curiosity to do the research and put the effort in. But if I did, I think your sports team analogy is a good one. Now, if you could just figure out the magic to always know when to bench your perennial runner at the exact right time, you’d be famous.
Haha, I own plenty of index funds too.
But you’re right — knowing when to bench your winners isn’t easy. You REALLY need to follow the business. Most people probably don’t have time for it.
Considering the potential wealth increase, apparently you better make time to follow some of these companies. Setting priorities is difficult, but with you it really paid off! Nice move.
I’m mainly a mutual fund investor based around time adjusting funds so I don’t feel the need to rebalance each year. However part of me would love to find the next big thing and ride it to the top like you’ve just done with FR!
It certainly wasn’t “the next big thing” when I invested. It looked like complete crap to almost everyone.
FR has clearly crushed it for you. Well done in picking that stallion out of the field (in keeping with the pony talk).
While it has proven your point (let a good investment run), I’m guessing your stock pickings don’t average out to 900% returns during this time period (if they do, i’m giving you all my money to invest!). With the S&P returning somewhere around 200% during this time, isn’t it more conclusive to look at the returns of your entire portfolio versus just one stock? When looking at a more macro level, I’m finding it difficult to get my brain comfortable with not rebalancing as I’m not sure if a couple of “stallions”, mixed in with some “horses slower out of the gate” beats the overall market. With that said, I’m probably missing your point as I’m trying to use your analysis to re-evaluate my investment approach of ETFs (playing the market) versus stock picking.
Whatever the case, you’ve got me thinking here.
Over the past 10 years we’ve either matched or exceeded the S&P during that time period. During that time we held a huge amount of fixed income investments (mostly preferred shares), meaning our “stallions” had an outsized effect on the portfolio.
As Buffett would say, outstanding performance is due to just a few winners.
I like your article because I agree with two of your points: 1) Rebalancing doesn’t add value to long-term investors
Ironically, a lot of index investors claim superiority to dividend investors because they state that their investments are more tax efficient. However, they conveniently forget to tell you how much they lose in those frequent re-balancing exercises. ( they only tell you when they came out ahead). They also forget to share the opportunity cost of foregone upside that was traded in for the “comfort of following a neat mathematical model”
2) Letting your winners ride
I am very much convinced that the best strategy is to do as best as you can in identifying a group of investments, and to then hold on to them for as long as humanly possible. In fact, any time i have sold anything, I have almost always found out later that the sale was a mistake.
So I have found that I should just leave my portfolio aside.. Others that are much smarter than me have said great things about this:
” It was never my thinking that made me any money, it was my sitting”
“Cut your losses, and let your profits ride”
DGI
Thanks DGI! Great quotes!
Basketball analogy! Nice!
From an individual stocks investing point of view, “you want to keep this winning gem on your “team”. Maybe you even double-down on this winner.” makes sense. But the tough part is predicting who the winners are. Very few people in the world can do this and have the passion to research the hell out of the companies and continue predicting the winners. And even then, they could be wrong. Until I can magically morph into Warren Buffet, I’ll stick with index funds 🙂
It’s worth stating that most investing errors really aren’t all that bad — you can learn a lot from them, and as long as you’re making slightly more correct investing decisions you’re bound to do OK.
I must also stress that good investing is not necessarily about predicting winners. Sometimes it’s about finding those ‘average’ players at just the right time. Sometimes it’s about understanding the psychology of the market.
More often than not, I’ve stumbled onto my winners rather than predicting them. I just had the good sense to hold on once I realized it was a winner.
You’re absolutely correct though — for the 95% of the world that isn’t willing to put in the effort, then index funds are the way to go.
IMP, Individual stock picking is not that difficult nor is it too hard if you do your due diligence in researching it (research the hell out of them- no you don’t – that’s just your opinion). Yes, you will have some winners and some losers, but if you hold long term on solid companies, you should be fine. Index funds are great and I have them on my Roth IRA, HSA & Rollover IRA. But depends on your situation. As a 42 yr old, I spent my paycheck every 2 weeks until someone taught me the “why” and the “how” to budget & save money. I discovered the FI/RE community & investing at age 46. So, if you’re looking to early retire sooner or in my age group, you need to find assets (talking stocks here) to really grow – you need to invest in growth stocks. If I just invested in index funds (which is great) I don’t think I would have gotten my net worth from $39k to $770k ($262k is real estate) in only 6 years.
I agree with this entirely. As a trader, it was hard to let profits ride and cut losses sometimes. Human psychology is very risk averse.
As an aside, does this mean I should let all this crypto ride? I’m half kidding, and really unsure.
Any good stock picks at the moment? It’s always fun to have a play portfolio.
Actually yes…
There’s going to be a stock picking contest in 2018 between several pf bloggers. I’m not ready to announce my picks yet, but soon!
Mr Tako thank you so much for this article. As a relatively new investor, I’ve often read about rebalancing, and selling your winners.
However – and maybe this is through looking at things with unbiased eyes – this never made any sense. Why would one wish to sell their best performing stocks, on a presumption that, as they performed so well last year, they will certainly plummet the next.
Thank you again for enforcing my somewhat innocent theory.
Kind regards, and seasons greetings from England.
It really depends upon who you ask. If you read studies done by brokerage firms they almost always say “rebalancing improves performance”. They profit from rebalancing costs of course.
Yes, under certain very specific mean reversion conditions it can give a tiny boost… but those conditions might not happen in the real world outside of mathematical models. There’s endless arguments about this, but any advantage to rebalancing is probably just statistical noise.
Really the more interesting question in all of this isn’t about maximizing returns, it’s about how we define risk.
Nicely done Tako. I’m a big fan of trailing stop losses. It lets your winners run until they stumble. This lets you pick up some big gains while covering your risk.
Also, I am human or cephalopod and have checked the appropriate box.
Financial Velociraptor recently posted…Monday Trades – 22.79% annualized return
Interesting point Velociraptor. I haven’t used a ton of trailing stop losses (some, but not many) due the inherent volatility of security prices. Prices can change up to 50% in a given year (plus or minus 25%) and those movements are essentially meaningless swings due to market emotion.
How do you typically set stop losses so you don’t get stopped out unnecessarily?
Great post. I’ve held onto Apple for years. I’ve been told many times to get rid of it, Glad I didn’t. One thing I have been doing is trying to keep it at about 25% of my portfolio. So over the past few years, I’ve been skimming off a few shares at a time. I’ve owned the stock since the 90s so these small sales do generate a capital gain. I use that and the dividends as part of my FI income.