Rule Breaker Mailbag: Should I Rebalance to Stick to My Allocation Targets?

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In this segment from the Rule Breaker Investing podcast, David Gardner dips into the mailbag and discovers two readers with very similar questions: When your investments rise and fall, the balance of your portfolio is sure to change. Should you rebalance it regularly to get back to the original levels, or does a buy-and-hold philosophy mean you ignore the apparent risk of having a larger share of your assets accounted for by those past winners? David's response will be extremely interesting to anyone who has been using allocation targets.

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A full transcript follows the video.

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This video was recorded on Aug. 30, 2017.

David Gardner: [With] this next one I'm going to combo two questions once again -- one coming from Josh and one coming from Dennis. Josh, you basically put it this way. "From what I've read, it may be prudent to rebalance every year back to the target allocations that you have; for example, something like 40% Rule Breaker stocks, 40% value stocks, 10% real estate, 10% cryptocurrency," you included.

"It might be prudent to rebalance every year back to those allocations, but that also seems somewhat counter to your advice, David, at least about individual stock picks. Stay with the winners and don't sell them." That's the way Josh puts it. Or in Dennis's case, Dennis said, "In a recent email your brother, Tom, had a few tips to help mitigate risk in a portfolio. One of the tips was not to let one stock exceed 15% of your portfolio."

Dennis, you said, "I have one stock, Netflix, that has grown above this level recently. Given your discovery that the Stock Advisor portfolio would have performed better if you hadn't sold any its stocks..." That's something we've talked about in the past. We went back and looked at all of Stock Advisor and realized that we would have done better if we'd never sold once. "Given that, should I sell part of my Netflix holdings to bring it below 15% or should I buy more of other stocks to dilute Netflix's share of my holdings?"

Fools all, the question is about rebalancing or having overweighted positions. And my best single shot at answering this question is that I don't use targets myself. I don't go in and say I'm going to have 30% domestic, 30% international value stocks, 20% in bonds. This kind of a thing. I totally respect that people do that.

And if you use a financial planner, or a professional financial advisor, often these are the terms that they're using. It is just the default framework that they use -- that you would have X% in this or that thing and Y% in this other thing. That's how they invest for their clients.

For me, I try to have -- and this number was referenced by our young investor earlier -- at least 15 stocks. I try to make those 15+ stocks come from some different industries. I don't overinvest in any of them. If I'm going to buy 20 stocks, I'll start with a 5% position in each of those 20. That equals 100%.

And then what I'll do is I'll let time play out -- I'll let the world happen -- and we'll see who wins and who loses. And I'm going to be wrong about some of those. I'm going to have some real dogs in my 20 stocks. I'm going to have some stocks that lose more than half their value.

But I'm also going to have stocks that rise well more than twice their value, especially if I let time play out. And so as this happens, instantly you'll be out of balance. Your portfolio will become imbalanced and in some cases it might be scarily overinvested in one, two, or three stocks all of which, by definition, would be your biggest winners. So fundamentally you're going to be dealing with something that's out of balance, that happens over time, and the things that you're most heavily invested in -- and arguably overinvested in -- are going to be the things that did the best. That probably had the best management, the best products or services, the best competitive advantage, and really helped the world most.

And the question you'll then have to ask is the one that is Dennis is asking. I now have more than X% in this stock. Should I? And my best answer to close this one, at that question, is you're going to know your own situation better than I will.

I'll say this. I've allowed stocks to become more than half of my net worth over the course of the past -- at different points in history -- if a stock absolutely took off as AOL did back in the day. And more recently we've had some big winners when you think about stocks like I've mentioned before, Netflix, Priceline, some others. So this can happen in member portfolios here at The Fool.

For some of us who are used to that, we can accept that kind of a risk. And also in my case, I have a little bit of extra benefit because most of my wealth is probably tied up in my company, so if my own portfolio imploded, which I don't intend that it ever will, I probably would still be OK in part because I have a big holding in my own company. Maybe you have a big real estate holding that I'm not talking to.

So each of us is allocated in different things that I can't really speak to, but you need to know what makes you comfortable sleeping at night, and especially as we age and get to a point where we need that money, you might want to think harder about reducing winning positions.

And to close this shaggy dog answer, my best approach to doing that, if and when you decide to shave down a position, is to do it incrementally. Is to say if your holding of Netflix is at 22% and your target for your portfolio, for a stock or a group of stocks is not 22% but just 15%, then rather than shave off that 7% all at once, I would highly suggest your programmatically trade. Let's just say 1% will go on the 15th of the next seven months. Just make it mechanical. Take any guesswork out of it. Make it simple and mathematical and that's my favorite way to reallocate.

So whatever percentages any one of us should be in, I hope that that tactic is helpful for you, whoever you are. To be incremental about it. And I would say in the end use your own emotions as your best guide to whether you are appropriately invested for you in a way that helps you sleep well. And I hope you do.

David Gardner owns shares of Netflix. The Motley Fool owns shares of and recommends Netflix. The Motley Fool has a disclosure policy.