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

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• 1. Portfolio Choice – The Strategic Decision
• Relevant variables
• The asset‐allocation table
• 2. Rebalancing – Portfolio Adjustments
• Why, when, and how

Winning Investment Strategies

Portfolio Choice & Rebalancing

Javier Estrada Winter, 2014

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

A Very Common Mistake

Typical portfolio formation

‘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

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Strategic Decision

Determine the appropriate allocations

Stocks Bonds

Alternatives (Others)

These proportions determine most of the portfolio’s return

Upside Protection Diversification

Go Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Strategic Decision

How to make this decision?

Focusing on two (three) variables

Holding Period

Choice/Restriction

Risk Tolerance

Preferences

Target Return

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Strategic Decision

There are many rules of thumb

And many (many) questionnaires/recommendations

P(B) ≈ Age P(S) ≈ 100 – Age

Critically, you must assess your ability to withstand losses

Go2 Go1 Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Investor Questionnaires

They aim to suggest an asset allocation

Taking into account the holding period Taking into account risk tolerance And other variables (experience, …)

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Strategic Decision

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – Why?

Two basic reasons

Holding period Differential returns

As time goes by, increase the allocation to bonds, and decrease the allocation to stocks Revert the asset allocation to that chosen in the strategic decision Target‐date/lifecycle funds

Go‐2 Go‐1

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – When?

Two (three) basic possibilities

Time

dependent

Threshold

dependent At predetermined points of time When the allocation shifts by more than x% from the initial allocation

Or a combination of both

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – When?

Time‐dependent rebalancing

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

Go

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – When?

Threshold‐dependent rebalancing

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

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Rebalancing – How?

Basically in two ways

Additional capital available Add capital to the underweighted assets No additional capital available Sell overweighed assets, invest funds in underweighted assets

Tax implication

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – Why, Really?

Keep in mind an essential point

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

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

In Short

• Stocks, bonds, and alternatives
• They are enough for most individual investors
• This strategic decision determines most of the risk

and return of the portfolio

• 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

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Appendix

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Strategic Decision

Back (*) Brinson, Singer, and Beebower, "Determinants of Portfolio Performance II: An Update."

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rules of Thumb

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rules of Thumb

Back

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Holding Period

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Risk Tolerance

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Risk Tolerance

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Holding Period & Risk Tolerance

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Holding Period & Risk Tolerance

Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Risk Tolerance (ETFs)

Back

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing

Back Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Target‐Date Funds

Back

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Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – When?

Back Javier Estrada IESE Business School Barcelona Spain WININV Winter, 2014

Rebalancing – Vanguard

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