Rebalancing your investment portfolio – The Michael Jordan way

portfolio-rebalancing-jordanRebalancing investments is one of the most important steps in portfolio management for both individual and institutional investors. The main purpose of rebalancing is to ensure that your portfolio maintains the desired asset allocation, so that you can meet your goals while also preserving your wealth. With many methods for rebalancing available, here I will outline some and describe which one I think is best.

Asset Allocation and Drift

Asset allocation is the ratio of specific asset types (such as stocks and bonds) held within an investment portfolio according to the strategy in place. This is usually set out in the Investment Policy Statement (IPS), a signed document which states the investor’s goals along with factors such as target asset allocation percentages, expected returns, investing horizons, investment philosophy and rebalancing and review schedules. It is important to have an IPS as it can help you stay on course and be a reminder of what you are investing for.

A common and easy way of determining asset allocation is “your age in bonds”; for example, a 30 year old’s portfolio would ideally contain a 30% bond/ 70% stocks mix.

A common and easy way of determining asset allocation is “your age in bonds”; for example, a 30 year old’s portfolio would ideally contain a 30% bond/ 70% stocks mix. Of course, in reality this mix is hard to maintain due to the continual change of asset prices as the stock market moves up or down. After a while portfolio ‘drift’ can occur, leaving the portfolio looking like this – 20% bonds/ 80% stocks. This scenario is not ideal for our investor as their portfolio would have started to become more aggressive than intended and therefore more vulnerable to greater volatility.

Rebalancing Strategies:

Buying and selling assets depending on performance

To counter this situation, the most recommended method seems to be; to review the asset allocation at a particular interval, perhaps yearly, and then achieve the target asset mix by selling certain assets to buy other assets. In effect, you would be selling your best performing investments which would have inflated in price, in-order to buy your worst performers at depressed prices – “buy low and sell high”. On paper, this method seems reasonable, straight forward and simple. However, personally I do not agree with this strategy and here is why.

Rebalance like Jordan

Michael Jordan is arguably the greatest basketball player and sportsman who has ever lived. Well known as the star player for the NBA’s Chicago Bulls and USA Dream Team in the 1980’s and 90’s, Jordan is a Hall of Famer who claimed six championship titles, with two sets of three consecutive wins. Truly, Jordan is the Greatest Of All Time (GOAT). Jordan has repeatedly won a string of awards and accolades including Most Valuable Player (MVP), NBA All Star, Olympic gold, college awards and rookie of the year. He holds records for highest season average points per game (30.12) and career playoff scoring average points per game (33.45).

Now back to how this relates to rebalancing your investments. Imagine if your portfolio was a team of five basketball players, with Michael Jordan being one of them. As the end of the season approaches a tight race to the finish ensues among the top few teams in the league, including yours. At this point you decide to review your team with the aim of getting the best out of them.

You realise that Jordan has been consistently been outperforming all the other players by a good margin. What do you do; do you bench you best performing asset and bring in less effective players? I know what I would do which is to retain as much as of my best performers on the court as long as I can. Benching Jordan would be akin to selling off you best performing assets. To me it makes no sense to sell your most important performers at any point in the wealth building stage.

“Inactivity strikes us as intelligent behaviour”

The quote above is by Warren Buffett in his 1996 Chairman’s letter to Berkshire Hathaway shareholders. In essence, the advice is that investors should not feverishly trade their positions in highly profitable ventures due to what news reports or other predictions say. The letter goes on to state:

“When carried out capably, an investment strategy of that type will often result in its practitioner owning a few securities that will come to represent a very large portion of his portfolio. This investor would get a similar result if he followed a policy of purchasing an interest in, say, 20% of the future earnings of a number of outstanding college basketball stars. A handful of these would go on to achieve NBA stardom, and the investor’s take from them would soon dominate his royalty stream. To suggest that this investor should sell off portions of his most successful investments simply because they have come to dominate his portfolio is akin to suggesting that the Bulls trade Michael Jordan because he has become so important to the team”

The take away from this is that it is important to think carefully before selling any investments while rebalancing as this may negatively impact future returns. It is best to rebalance by buying more of underperforming assets with fresh cash rather than selling others. This may prove difficult in future as portfolio size increases but I feel that this is the best strategy and investors should not fear good performers dominating their portfolios.

For interesting investing insights, tools, financial  independence ideas, index fund tips and compilation of the best articles on this blog you can read my ebook here:Compound Your Freedom Book

Leave a Reply

Your email address will not be published. Required fields are marked *