I was talking with a college finance professor last week and I asked him what he thought was his best idea for portfolio management that isn’t widely accepted or encouraged as part of conventional wisdom. He told me this: “Only rebalance using cash, be it from investments or the new money you have available from your job.”
He said he learned that by forty years old when he saw the stocks he sold in his thirties to rebalance kept going up and raising dividends. You know the C.S. Lewis quote about how we are never entitled to know the answer to the question “what might have been”? Well, stock market investing is the one area of life the great Christian writer didn’t take into account. If you sell Coca-Cola at $35 per share when its quarterly dividend is $0.305, you will be there in 2019 when the stock price is $75 and the quarterly dividend is $0.60 per share. When you see that you traded that stock for some bonds yielding 3%, you might want to punch yourself somewhere.
After all, why is it that someone sells a stock? Usually, because it appreciates a little. Here’s the thing: Companies like General Mills, Exxon Mobil, Procter & Gamble, Stanley Black & Decker, and Colgate-Palmolive have been growing profits for a century. When a business can keep growing profits like that, the price of the stock will be marching directionally up (remember Tom Lewis’s line about stock prices of great American businesses being like a man walking up the stairs with a yo-yo). In other words, it is very possible that the reason a stock comes to take up an inordinate size of your portfolio is because it is a superior business delivering superior returns.
I definitely can see the wisdom in treating diversification as something that happens over time, rather than all at once. Let’s say you want to enter retirement with a balanced portfolio that consists of 65% stocks and 35% bonds. Imagine if, say, Conoco Phillips had become the king stock of your portfolio. Someone with 4,000 shares of Conoco to his family’s name could take those $11,680 cash dividends each year and use them to buy bonds. When and if Conoco raises its dividend next year, you can repeat the process, buying bonds until you get something that represents your allocation.
The appeal of not selling assets to meet rebalancing needs has a three-pronged benefit: (1) you are avoiding capital gains taxes, keeping as much money working for you as possible, (2) you are possibly retaining an ownership stake in a superior business that is continuing to give you superior results over time, and (3) presumably, you are retaining an asset that you are deeply familiar with, thus making sure that the “comfortability” portion of your portfolio remains high.
Every year, right around January 1st, the financial websites across America blare “It’s time to rebalance” and talk to their audience like they’re mindless zombies that are incapable of getting a feel for the quality of their existing assets and must always hover around 60/40 or 65/35 stock/bond allocations. I don’t think the answer to an investing life is selling Coca-Cola to buy US bonds to keep your abstract ideal portfolio allocation intact, and then going to bed thinking you achieved victory.
Certainly, there are some people who do need to sell assets as part of rebalancing. Weird things can happen as part of being an employee, inheritor, business seller, or whatever, that can momentarily have most of your fortune tied to one particular stock. If one company going bankrupt could set me back decades, sell buttons will be pushed. But before deciding to sell, I think a lot of taxes and arbitrary relinquishing of high-quality assets could be avoided by asking yourself the question, “Can I use the cash from my job and the income from my current investments to gradually shift my portfolio allocation over the course of 5-10 years to something I would find desirable?”