Knowing when to sell: Using a rebalancing system can keep emotions at bay

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"How to Find the Best Dividend Stocks"; "Stocks for a Bear Market"; "Five Stocks to Take Advantage of Central Bank Policies" – just about everywhere you look in the financial media, you'll find tips on buying stocks.

Far, far less often will you find advice on when you should sell a stock, however – and knowing when to sell may be even more important than knowing what to buy.

I have previously written about my belief in using a sell system that employs quantitative and fundamental criteria and fixed-interval "rebalancing" dates. To recap: On these dates, I keep stocks that still have top scores on my fundamental-based, guru-inspired strategies; I sell those whose rankings have slipped and replace them with new, higher-scoring companies. This keeps emotions – the great enemy of the investor – at bay by sticking to the numbers and buying and selling only at predetermined intervals. Of course, that leads to another key question: How long should those intervals be? Monthly? Quarterly? Annually?

The answer is that it often depends on the specifics of the strategy you are using. And that means you need to do some work before you buy – and even after you sell – a stock.

For example, one of the many guru-inspired portfolios I track is based on an approach that little-known accounting professor Joseph Piotroski outlined in a 2000 study. A 20-stock, monthly rebalanced U.S. portfolio picked using my Piotroski-based model, which I started tracking in 2004, has been the worst performer of my 12 20-stock Guru Strategies when using a monthly rebalancing interval.

When we extend the rebalancing period to a full year, however – the time frame Prof. Piotroski used in his study – the results are much different. The Piotroski approach then becomes one of my better performers, having returned 127 per cent since inception in early 2004 versus 81 per cent for the S&P 500.

On the other hand, my Motley Fool-inspired approach – based on a strategy outlined by Fool co-creators Tom and David Gardner – has behaved in opposite fashion. A 20-stock annually rebalanced portfolio picked with the strategy is up just 57 per cent since its 2003 inception, significantly lagging the S&P. A quarterly rebalanced version is up 153 per cent, however, well ahead of the index. A monthly rebalanced version? It's up 276 per cent compared to 107 per cent for the S&P 500 since mid-2003.

Different strokes

Why do different strategies work better with different rebalancing periods? The reasons are likely myriad, and with smaller portfolios it's certainly possible that a bit of randomness is involved, too. But I think there is some logic behind the performance of my Piotroski- and Fool-based approaches.

The former is a deep value approach, targeting stocks with book-to-market ratios (that's the opposite of the price-to-book ratio) in the cheapest 20 per cent of the market. Deep value strategies focus on companies that are out of favour and often require patience – you have to wait for the rest of the market to identify the value you see in these unloved bargains. It makes sense that a deep value strategy such as my Piotroski approach would work better with a longer rebalancing period – the longer time frame provides time for the market to recognize the value in these holdings.

The holdings of the Fool approach don't need that much time. The strategy is focused on growth and momentum, looking for companies whose sales and earnings grew at least 25 per cent in the most recent quarter and whose shares have been outperforming at least 90 per cent of other stocks in the market over the past 12 months. These shares are already rising.

The danger with hot stocks, however, is that when they lose their lustre, they can come tumbling down quite quickly. A shorter rebalancing period may well be helping the Fool portfolio cut its losses when the market turns against a stock.

The bottom line

What does all this mean for your portfolio? I think there are few things to keep in mind:

• Rebalancing forces a disciplined buy/sell methodology into the investment process, removing emotions and biases that oftentimes hurt performance.
• Ben Graham – the man known as the “father of value investing” – would have considered rebalancing (even on an annual basis) speculative in nature, but when a stock’s fundamentals change and there are better opportunities in the market, having a systematic way to get those into the portfolio is important over time.
• Keep in mind that rebalancing means you are monitoring and updating your portfolio. Having the right investor mindset is imperative. If you are the type of investor who gets emotional and has difficulty staying disciplined, certain rebalancing plans might be difficult for you to follow. Understand yourself and find the rebalancing period best suited for you.

Finally, following a set rebalancing methodology is not for everyone, but for investors who are using stock screens and quantitative approaches, having a rebalancing method is an important part of the investment process.

John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the National Bank Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service.