Tuesday, February 17, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (February 17, 1998) -- Over the weekend, I received e-mail from several readers who were interested in using the Keystone Dozen approach but unsure how to go about the rebalancing process each month.

If you're unfamiliar with the Keystone Dozen idea, it's simply a method where you buy the top Keystone stock each month that's not already in your portfolio. Once your portfolio is in place after the first year, you'll hold a total of twelve stocks, each with a different purchase date.

The advantage to this is you can start with less than $12,000 and add positions gradually as you continue to save until eventually you have a full 12-stock portfolio. It also allows you to add new money regularly without increasing your commissions. Trading is capped at 24 transactions a year (2.0% on a $12,000 portfolio, only 0.5% on a $50,000 portfolio). By choosing the highest-ranked stock each month, you may also find your overall returns exceed those of a 10- or 15-stock portfolio chosen all at once.

So, what about when the first year wraps up and you begin the monthly adjustments? If your account is a taxable one and you're willing to carry a small margin balance, the problem of rebalancing is simple. When you replace a stock, buy the new one in an amount equal to 1/12 of your portfolio value at that time. So, if your current total portfolio value is $36,000, the position you're adjusting this month should be worth $3,000.

If the stock you're replacing has been an underperformer compared to the rest of your portfolio, the position will be a little smaller than that 1/12 ideal, so you borrow the difference on margin from your broker. If the position has been a stellar achiever, you'll be pulling a bit out when you buy the replacement, which would pay down your margin balance by that amount. This way, each stock is perfectly balanced once a year. For example, if the stock you're replacing was only worth $2,400, you'd borrow an additional $600 to buy the new stock with $3,000. On the other hand, if the stock you're replacing is now worth $3,800, you'd only buy its replacement with $3,000 and let the extra $800 pay off a portion of your margin balance.

This process won't work in an IRA, of course, because they're not eligible for margin leverage. If you want to keep these rebalancing efforts somewhat precise in an IRA, you may have to accept a small cash balance as a rule instead of being 100% invested all the time. You would use your cash balance just like the margin account in a taxable portfolio, using the extra cash when you're replacing a stock that has underperformed and stock-piling a little cash when you replace a stock that has out-paced the rest of your portfolio. And you may simply have to accept some imprecision in the weightings. But getting close is fine.

This is one simple plan for a rebalancing effort. You may find another that you like better. If you do, please share it with us on the message boards. Fool on!

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