In the article on Asset Allocation, you have already learned how to properly assemble individual stocks in a stock's portfolio. In order to maintain the proportionality of the individual shares, even when price changes occur, it is necessary to regularly balance your portfolio.
In this article you will learn the "maintenance" of your Fair Value Calculator stock depot. This does not just mean that stocks should be bought and awaited. No! The "maintenance" of the depot includes ongoing work such as rebalancing.
We have developed these steps on the basis of past researches and studies as well as personal observations.
Do not worry it's not a lot of work but brings you crucial benefits over the years!
Selection of stocks
According to the fair value strategy, you can select and buy stocks in your portfolio. Only select shares whose fair value is higher than their current price in the stock market. On fairvalue-calculator.com you can easily calculate the fair value of each stock. To buy the shares, you should open an online account with an online broker in your home country, since the expenses here are significantly lower than at your local bank. Create a stock portfolio according to the right asset allocation and according to your risk appetite.
In the article on asset allocation, you learn how to build your stock portfolio. The mixture of different asset classes enables a reduction of risk. Over the years, some stocks in your portfolio will outperform others. When a stock gains heavily, its percentage in the portfolio also increases. Therefore, you should constantly adjust your portfolio to minimize the risk through the right asset allocation.
Now that you have set your personal asset allocation, you should always try to align all the assets in your portfolio with their original percentage in the overall stock portfolio. There are three reasons of doing so.
Historical data suggests that such a portfolio's care achieves a better return than, for example, a simple buy & hold strategy.
Second, your asset allocation should be tailored to fit your risk profile. If the percentage of different assets is blurred, the original sense of individual asset allocation is lost.
Third, if you keep buying the stocks that have made great performances and just hold the weak performing stocks without rebuying in the portfolio, you would almost every time buy expensive.This is not the philosophy of the fair value calculator strategy.
The best time to buy a stock is at cheap stock price. When the weakest performing stocks are permanently readjusted to their original portfolio-percentage you keep your risk management and buy stocks cheap.
Over the course of several cycles, a stock in the portfolio will increase its portfolio-percentage if it yields a higher return than another asset. Then it is always advisable to rebalance the portfolio. During rebalancing, choose periods that fit your deposit volume, as each rebalancing may incur tax and transaction costs. The rebalancing should only be used for a long investment horizon of several years, rebalancing intervals of 1-2 years are considered useful. If a stock is roaring you should sell a part of it and reinvest into an other fair value stock to diversify risk.
When to sell a stock
The last question is when to sell a stock. In summary you will now have a great portfolio of good fair value stocks and every time you make a profit, a new stock is added. But what if the stock's performance turns negative?
If the depot goes down, we just wait an average of 7 years until the haunting is over and the stocks are very likely to be back in positive territory. But how to deal with individual loss shares?
Here I would advise to compensate the losers with profits of the other shares in the depot, if the fair value of the loser share has not changed!
So before I use the profits to buy a new stock into the portfolio, I would adjust the loss shares back to the original portfolio-percentage in the depot. But as I said only if the fair value here is still higher than the stock market price. A new insight into the current fair value is advisable.
If, for example, the fair value has deteriorated after two years and the fair value has fallen below the current market price after a new calculation, then you should sell the position instead of adjusting the position again. But here only if the stock is in minus. Stocks which are in the plus, no longer have to be judged on the fair value, only their position size must be adjusted.
Decision Tree in the process of rebalancing your Stock Portfolio
In the following graphic we show the explained rebalancing. The following decision tree is an example of how you could proceed after a period of 1 to 2 years to adapt individual stocks that have developed differently according to the selected asset allocation.
In the chart above, a portfolio of three Fair Value Calculator stocks is put together at the beginning. Shares A, B and C are shares that have a higher fair value than the current market price in accordance with the fair value calculator strategy.
After a reasonable period of time, the stock portfolio should be balanced again. In this example, we have chosen a time span of 1 to 2 years.
After these 1-2 years, the individual stocks have developed differently. Share A has only a 7 percent part in the portfolio due to a price loss, share B has kept its price and stock C has doubled due to a strong price gain.
Now there are 5 options for each position:
- Balance Buy: One share has fallen in price and will be adjusted by buying back to an equal share in the portfolio.
- Buy: Profit is used to buy a new Fair Value share in the stock portfolio.
- Hold: One share has barely changed in price and its stock portfolio share has therefore remained constant.
- Sell: The stock has lost value and the newly calculated fair value has also fallen below the current stock market price.
- Balance Sell: The stock has made a strong profit and is adjusted to the original portfolio share.
In our example, therefore, Stock A is reviewed for fair value after the price has fallen. In general, only stocks that have lost value must be updated for fair value. If the fair value of the stock is higher, you can buy more, if the fair value is lower than the current market price, you could sell the position.
In the result, we have adjusted share A so it occupies a 25% stake in the portfolio with 4 shares.
Stock B has held the price, so i also should take about 25% of the new stock portfolio.
Stock C has experienced strong growth and is therefore being sold in balance, with the funds stock D is added into the stock portfolio. Stock C and the new D now also hold 25% in the stock portfolio.
Now the portfolio is balanced again and more diversified by the addition of the share D, which serves to minimize risk. If you follow this strategy, you will soon have a portfolio with many different high quality stocks and have always bought stocks cheaply.
Articles About stocks and stock market
Dr. Peter Klein, BA
According to studies the occasional balancing of the portfolio brings a performance advantage. This means that constantly balancing stock performance with position size contributes to safety and higher returns. By maintaining the correct asset allocation, the risk profile of the equity portfolio remains the same.
At fairvalue-calculator.com, we offer the opportunity to find cheap stocks.