Did Robin Hood Have The Secret To Portfolio Management?

6th Nov '14 by Ben Hobson

5 comments 13164 reads

When it comes to rebalancing a portfolio, industry advice tends to focus on making sure that your exposure to stocks, bonds and other assets matches the risk you can stomach. But it’s worth remembering that the same goes for a portfolio that’s 100% invested in shares. On the one hand rebalancing can stop a portfolio drifting and becoming over-exposed to a small number of stocks. On the other, there is evidence that it can help you squeeze an extra return from something that most investors instinctively fear - volatility.

In this series on Portfolio Management we’ve been exploring how investors can manage their risk in rules-based, equally-weighted stock portfolios. Stock market volatility - the ebb and flow of daily price swings - is part of the risk that investors take for owning shares. A popular topic recently (based on research that dates back 40 years) is that low volatility shares may actually outperform high volatility shares over time. But rather than choosing between the two, there may be a way of surfing the volatility wave, and even earning a profit premium from it, simply by having a well diversified portfolio that’s rebalanced regularly.

Steal from the rich, give to the poor...

One of the big behavioural obstacles to rebalancing is that it means trimming strong performing positions and bolstering the underperformers. In his book Market Sense and Nonsense, Jack Schwager calls this “Robin Hood investing”, or “taking from the winners and giving to the losers”. To test its impact, Schwager crunched US data from between 2005 and 2010. He found that eight out of 10 randomly selected portfolios from 10 fund managers produced better risk / returns when they were rebalanced monthly than those that weren’t rebalanced at all. Now, Schwager stresses that his results are not conclusive proof that rebalancing improves performance and lowers risk. Rather, what he found merely supports the argument. But Schwager isn’t the only one to suggest that rebalancing can actually improve returns...

In 2012, US investment adviser Parametric Portfolio Associates looked at whether it was possible to profit from volatility. What they found hinged on the point that, apart from being associated with risk, volatility also has a big influence on how returns compound over time. What does that mean? Well, to borrow Parametric’s example, let’s take two stocks - Apple and Cisco. Over 20 years one dollar invested in each grew to $34…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Edward Croft

6th Nov '14

The thing about rebalancing is that it seems to go against that old maxim of...

"Run your winners, cut your losers"

There are a few things I've wanted to write about lately including "Parrondos Paradox" which shows that you can turn 2 losing assets into a winning portfolio through rebalancing. I think the maths around rebalancing are particularly fascinating. We will test out the Cisco & Apple portfolio tested above and see !

lightningtiger

Cisco immediately rings a bell with me because it came up from my 700 club as an original stock from Israel which the US bought later. Looking back on my notes, others have been Microsoft, Intel, & Dell. Also written down is "never invest in an idea you can't illustrate with a crayon". This is why I am so interested with PLUS 500.
I give some of my portfolio profits to the 700 club each month @ http//cbn.com/700club, with a bit of extra cash as a lump sum as and when I can, with good deals resulting in profit.
So I can say that I am blessed and highly favoured.
Trying to be a bit of a Robin Hood myself I guess.
Rebalancing is a must in my book. The timing of just a few days can make a big difference.
Four things need to be taken into account:
1. Bid & Offer spread.
2.Trading costs.
3.Ammount of money traded
4.Movement in the share price
As an example recently Fitbug bought @ 2.95p offer & sold a day later @ 7.2p bid with dealing costs £23.90. That is up 143% and very rarely happens that fast. Spotted in Stockopedia price gainers today, dealt with Hargreaves live prices.

Now lets look at another deal with Plus500 Sold @ 528.65p bid & bought back again a few days later @ 500.00p offer. The bid/offer spread is about 5p depending on the number of trades on that day. This was done to buy some Fitbug stock.
The same dealing costs apply of £23.90. Therefore the break even number of shares to be traded is about 83, around £450. Less than that it costs. More than that there is a profit and it is worth doing, if you get it right.
The interesting thing that comes out of this is that the high & low of Plus500 on a daily basis averages about 25/30p so there is still room to trade. Buy low sell high. It might be worth trying out on paper first, but probably needs about £5k at least to deal & would work better when the trades are above average volume thus reducing the bid/offer spread. At the end of the day it was a win- win situation & a few more extra Plus500 shares in the portfolio and another different share was purchased.
Cheers Lightningtiger

marben100

16th Nov '14

Just for the record, I'd just like to state that the type of rebalancing strategy described is very much the one I adopt to manage my own portfolio. I don't rebalance at set times, but when any given holding goes sufficiently above or below my target weight. I.E. far enough below or above that the rebalancing amount exceeds my minimum buy/sell quantum, which is about £2,000, so as not to incur too much cost from commissions etc. That target weight, in turn, depends on my own view of the risk/reward balance in that stock, and how risky I perceive the investment to be (considering risk to be the likelihood of permanent loss of capital not volatility).

In general, the strategy has worked well and has helped to lower my weighted average entry price for stocks that have proved volatile, whilst moderating risk for investments that have just become too large for comfort within my portfolio.

I don't set too much store by the "run your winners" adage (though as with most such adages it contains a grain of truth). For me, it leads to overconcentration and risk of large losses if things go wrong with one individual company.

Cheers,

Mark

Mark Simpson

Ed,

Ilmanen does a good summary of the academic evidence for diversification return in his book 'expected returns' if you haven't read it yet then I suggest you get a copy...I think it would be your sort of book.

It seems that rebalancing is effective for all but the most widely varying expected returns such as low yield t-bills vs (inexpensively priced) stocks.

His summary on this topic p488 says:

The above calculations assume returns with zero autocorrelation, so diversification return does not rely on mean-reverting asset prices. If asset returns are negatively autocorrelated, performance may be further boosted by picking an expedient rebalancing interval. (This is much easier with hindsight.) Conversely if returns exhibit short term momentum, very frequent rebalancing can detract from performance.
In an ideal world of zero-autocorrelated returns and no trading costs, very frequent rebalancing makes sense because it reduces bothe tracking error and (typically negative) covariance drag. However the presence of trading costs and, possibly, short-term return momentum make longer rebalancing intervals more attractive.

So it seems the paradox is resolved in the choice of rebalancing period which will vary depending on the choice of portfolio assets.

Raphael Battu

2nd Jan '19

Hello Ben,

Thank you for this great article.

Could you provide me with the source / original article : US investment adviser Parametric Portfolio Associates ?

Thank you and happy new year to all the team of Stockopedia !

Did Robin Hood have the secret to portfolio management?

Steal from the rich, give to the poor...

Unlock the rest of this article with a 14 day trial

About the Author

Ben Hobson

5 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...