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The Great Rebalancing

Traders Magazine Online News, October 17, 2018

Jared Dillian

A friend of mine from a former life resurfaced and asked if I would look at his portfolio, which I was happy to do.

I felt a bit like an emergency room doctor who looks at a patient and can immediately diagnose a very obvious problem, like, his arm is missing.

My friend started out years ago with a small position in Apple, which turned into a very large position in Apple. What was once 2% of his portfolio was now 40% of his portfolio. Basically, his entire retirement was tied to Apple’s fate. People believe in Apple, but it’s still one company—fallible and prone to stupid behavior, like all large organizations are.

So the obvious solution is to rebalance the Apple holding. Sell Apple, and buy other stuff (which we will get to in a second).

People have a tough time rebalancing. A stock does really well for them, and they get attached to it. This is known as endowment effect. People have no problem selling small winners, but they have a hard time selling big winners—even when that position has reached a trillion-plus market cap and probably doesn’t have a lot of growth left in it.

Even when that position has basically become systematic, undiversifiable market risk.

Even when, if you told people they were holding an index, they would probably sell. Psychologically, people just can’t do it when they’re attached to the company.

We have had a very long bull market and there are quite a few beanstalks that have grown to the clouds. I suspect my friend’s portfolio looks like a lot of people’s portfolios, if they were left alone for a long period of time—one or two home run stocks dominating the returns of the portfolio, with everything else basically going nowhere.

A portfolio is like your landscaping. You have to tend to it every once in a while or it gets overgrown.

You shouldn’t wait to rebalance once every fifteen years. Once every 1-3 years will probably suffice.

Anyway, I wasn’t done playing portfolio doctor. There was one other big, glaring problem.

Asset Allocation

I said to my friend, you are 45 years old. So let’s round up to 50. That means that you should have a 50% allocation to bonds.

Or more.

My friend had a 2% allocation to bonds.

This is an extreme example—but maybe not! I suspect there are a lot of portfolios out there that look just like this one—dominated by one or two stocks, massively loaded up on equities, very underweight bonds.

The subject of asset allocation is a meaty one, and we’re not going to get deep into it here. But if you’re in your 40s or 50s and you’re rolling around with less than 10% bonds in your account, you have a serious asset allocation problem.

Part of the reason this asset allocation problem exists is because people aren’t rebalancing. If you have a 70/30 portfolio of stocks and bonds, what happens when the stocks grow over time and the bonds don’t? You end up with a 90/10 portfolio, even if that wasn’t your original intent.

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