A Very Common Mistake Javier Estrada Typical portfolio formation - PDF document

Winning Investment Strategies Portfolio Choice & Rebalancing Javier Estrada Winter, 2014 1. Portfolio Choice – The Strategic Decision • Relevant variables • The asset‐allocation table 2. Rebalancing – Portfolio Adjustments • Why, when, and how A Very Common Mistake Javier Estrada Typical portfolio formation IESE Business School Barcelona Spain ‘A little bit of this, a little bit of that’ Buying/selling the ‘right’ asset at the ‘right’ time With no strategy or global vision WININV Winter, 2014 1

Strategic Decision Javier Estrada Determine the appropriate allocations IESE Business School Barcelona Spain Alternatives Stocks Bonds (Others) Upside Protection Diversification These proportions determine most of the portfolio’s return WININV Winter, 2014 Go Strategic Decision Javier Estrada How to make this decision? IESE Business School Barcelona Spain Focusing on two (three) variables Holding Risk Period Tolerance Target Return Choice/Restriction Preferences WININV Winter, 2014 2

Strategic Decision Javier There are many rules of thumb Estrada IESE Business School Barcelona Spain P( B ) ≈ Age P( S ) ≈ 100 – Age And many ( many ) questionnaires/recommendations Critically, you must assess your ability to withstand losses WININV Winter, 2014 Go 1 Go 2 Investor Questionnaires Javier Estrada They aim to suggest an asset allocation IESE Business School Barcelona Spain Taking into account the holding period Taking into account risk tolerance And other variables (experience, …) WININV Winter, 2014 3

Strategic Decision Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Rebalancing – Why? Javier Two basic reasons Estrada IESE Business School Barcelona Spain Holding Differential period returns As time goes by, Revert the asset increase the allocation allocation to that to bonds, and decrease chosen in the the allocation to stocks strategic decision Target‐date/lifecycle funds WININV Winter, 2014 Go ‐ 1 Go ‐ 2 4

Rebalancing – When? Javier Two (three) basic possibilities Estrada IESE Business School Barcelona Spain Time Threshold dependent dependent When the allocation At predetermined shifts by more than points of time x % from the initial allocation Or a combination of both WININV Winter, 2014 Rebalancing – When? Javier Estrada Time ‐ dependent rebalancing IESE Business School Barcelona Spain The good Prevents ‘tactical’ adjustments The bad The allocation may be far from the target in strongly‐trending or volatile markets Annual/semiannual rebalancing is enough for individual investors WININV Winter, 2014 Go 5

Rebalancing – When? Javier Threshold ‐ dependent rebalancing Estrada IESE Business School Barcelona Spain The good Keeps the allocation closely aligned to the target The bad May imply very frequent rebalancing and therefore high transaction costs A 5% tolerance band is reasonable for individual investors WININV Winter, 2014 Go Rebalancing – How? Javier Estrada Basically in two ways IESE Business School Barcelona Spain Additional No additional capital available capital available Add capital to Sell overweighed assets, the underweighted invest funds in assets underweighted assets Tax implication WININV Winter, 2014 6

Rebalancing – Why, Really? Javier Estrada Keep in mind an essential point IESE Business School Barcelona Spain The target variable of rebalancing is not return The target variable of rebalancing is risk Rebalancing is a way to control the risk of the portfolio WININV Winter, 2014 In Short  Stocks, bonds, and alternatives Javier Estrada  They are enough for most individual investors IESE Business  This strategic decision determines most of the risk School and return of the portfolio Barcelona Spain  Critical variables  Holding period / Risk tolerance / (Target return)  Strategic decision  Focus on your ability to withstand losses  Annual/semiannual rebalancing with a 5% threshold is enough for most individual investors WININV Winter, 2014 7

Appendix Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Strategic Decision Javier Estrada IESE Business School Barcelona Spain (*) Brinson, Singer, and Beebower, "Determinants of Portfolio Performance II: An Update." WININV Winter, 2014 Back 8

Rules of Thumb Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Rules of Thumb Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Back 9

Holding Period Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Risk Tolerance Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 10

Risk Tolerance Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Holding Period & Risk Tolerance Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 11

Holding Period & Risk Tolerance Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Risk Tolerance (ETFs) Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Back 12

Rebalancing Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Back Target ‐ Date Funds Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Back 13

Rebalancing – When? Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Back Rebalancing – Vanguard Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014 Back 14