Thursday, May 14, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (May 14, 1998) -- With the Dozens method of building and managing a portfolio gaining in popularity here among Workshop readers, I've been asked to discuss how the ongoing rebalancing of such a portfolio might work.

Before I outline some options, however, let me back up and explain the Dozens Approach itself for new readers. Using your favorite stock screen, or a combination of two or more screens, the Dozens Approach has you buy a single stock each month, each time choosing the highest-ranked stock that's not already in your portfolio. By the end of the first year, your portfolio would hold a dozen different stocks, each chosen in a different month.

The advantage to this plan is that if you're a regular saver and like to put your new savings to work right away, you have twelve opportunities every year to add money to your portfolio. But as each stock is held a year (and a day), you're not losing the 28% cap on capital gains taxes and you're limiting your trades to 24 per year (two each month to replace each stock).

An issue of risk management I've talked about frequently is to keep your individual positions roughly weighted the same so as to spread the risk. Today's 13% drop in Hewlett-Packard <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HWP)") else Response.Write("(NYSE: HWP)") end if %> on an earnings warning is exactly why I argue for such a plan. The warnings took virtually everyone by surprise and in a very large position, this kind of drop can wreak havoc on your overall portfolio. If the stock is just one of a larger group of diversified holdings, the impact of such a drop is greatly minimized without your having to sacrifice solid returns.

A small problem exists, however, with the Dozens approach, in that you're not updating every stock on the same day and so rebalancing perfectly is impossible. I see two general plans for rebalancing this kind of an approach.

First, if your account is eligible for margin leverage, use that as a very small slush fund. When a stock reaches one year old, you'll re-evaluate it based on current rankings and in many cases, you'll replace it. To determine how much to invest in the replacement stock, take your total portfolio value on that day and divide by twelve. That way your new position is balanced against the entire portfolio perfectly for at least that one day. That's the best you can do, basing the value on what you're currently working with.

Depending on how well the stock you're replacing performed, and how much new money you've added to the portfolio since you bought the old stock a year before, you may have to use the margin slush fund to help you rebalance this stock. Let's say the position you're replacing is worth $4,000 and your total portfolio value now is $51,600. Your new position should be worth one-twelfth of that total, or $4,300, so you'd have to borrow an additional $300 on margin to buy the new stock.

On the other hand, if you're replacing a stock with $5,000 and your total portfolio is worth $51,600, you'd have $700 extra either to apply towards any outstanding margin balance, or to hold over until the next month's update.

Some months you'll have a surplus and in others, a deficit. Using your margin capability helps you even out each position once a year, and you'll never be generating a large margin balance this way.

Second, in an account where margin isn't allowed, you'll have to live with slightly less equitable rebalancing. You can use a slight cash slush fund if you wish, to perform the same function as the margin account -- parking extra cash when a position you're replacing has done extra well and borrowing money from the slush fund when you're replacing a laggard. But with our goal of trying to stay as fully invested as possible, you don't want too much cash lying idle in your account.

Don't fret if your rebalancing efforts don't come out perfectly even. The goal is simply to even out the positions somewhat once a year, so that no one or two stocks dominate the entire portfolio and set you up for a painful sell-off. Try to keep the model as simple as possible and save regularly; those are two crucial keys to a successful savings career in the market.

For Fools in the Lexington, Kentucky vicinity, I'll be doing a brief workshop and then a book signing this evening at 7:00 at Joseph-Beth Booksellers in Lexington Green. Hope to see you there! Fool on.

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[Robert Sheard is the author of the The Unemotional Investor (Simon & Schuster, 1998) available now at Amazon.com and your local bookseller.]