Never Retire Profile of the Week
Jim Peebles
Winning the Nobel Prize in physics elevates a person into a very select group that includes Albert Einstein in 1921 and, as recently as 2018, the University of Waterloo’s Dr. Donna Strickland. But receiving the award at age 84 is an achievement unto itself. Born in 1935 in Winnipeg, Manitoba, Jim Peebles was recognized last year for theoretical discoveries in physical cosmology, which is concerned with the origin and evolution of the universe. Fittingly, Peebles is the Albert Einstein Professor of Science, Emeritus, at Princeton University, where he received his PhD in 1962 and where he has stayed his entire career. Always interested in what he calls “underappreciated issues,” Peebles has been commended for laying the foundations for almost all modern investigations in cosmology, transforming a highly speculative field into a precision science. For the sake of knowledge itself, it’s good that Jim Peebles has never retired.
In my book The Ladder to Financial Independence, I outline six key steps for reaching that goal: commit to your financial goals, maximize your earnings, maximize your savings, invest well, protect against financial risks, and prepare an equitable and tax efficient exit strategy.
Here, I want to focus on number four – invest well. In particular, I’ll outline the reasons for rebalancing an investment portfolio.
Many clients and readers understand that the Dri Financial Group invests in stocks based on the buy/sell indicators produced by models we have created and back tested over many years, such as the Richard Dri Canadian Dividend Model that has been back tested since 1989. We don’t own a crystal ball. Nor do we follow the advice of TV “experts.” Instead, we follow the rule-based investment strategy that is the cornerstone of our models.
Sometimes, we’re told that the models are boring because we trade very little and never buy “high profile” stocks (like Bitcoin, Twitter, Uber, Peloton). We buy stocks that many have never heard of, like Cascades, a Canadian packaging company, or InterRent, which specializes in residential real estate and owns approximately 8,800 apartment units worth almost $2 billion. Maybe they’re not flashy, but these stocks have the same characteristics found in the best performers of the past 35 years. The second most boring aspect of our investment strategy is our policy of “rebalancing” our asset allocation and individual positions. I often hear, “Why would you sell a stock that is up and transfer the funds to a stock that is either down or not up as much?”
There’s plenty of proof for this strategy, but for clients who don’t care for numbers and charts, allow me to give an example. I call it the Nortel Pain.
Back in the late 1990s, when I was a young and carefree wealth advisor (okay, I’ve never really been carefree!), a 40-year-old Nortel employee hired us to help determine if she could retire. We began an investment portfolio review and a retirement projection. It didn’t take too long to realize that approximately 50% of her net worth was tied up in one stock, which also happened to be her employer: Nortel.
In case you forgot what happened at Nortel, here’s how Wikipedia summarizes the company’s dramatic and painful bankruptcy:
“At its height, Nortel accounted for more than a third of the total valuation of all the companies listed on the Toronto Stock Exchange (TSX), employing 94,500 worldwide, with 25,900 in Canada alone. Nortel’s market capitalization fell from C$398 billion in September 2000 to less than C$5 billion in August 2002, as Nortel’s stock price plunged from C$124 to C$0.47. When Nortel’s stock crashed, it took with it a wide swath of Canadian investors and pension funds and left 60,000 Nortel employees unemployed.”
Once we had completed our analysis, we explained our concern with the significant exposure to one stock. Our client owned Nortel in her employee stock ownership plan (ESOP) and in her RRSP. Obviously, we didn’t forecast a Nortel bankruptcy. But we were worried that if anything happened to Nortel, she could be financially ruined. We suggested gradually reducing the exposure to Nortel and diversifying into other stocks and other industries.
In response, she said something like, “I have worked for Nortel for 20 years. It has made me a millionaire, and I will NEVER SELL NORTEL.”
We tried to explain how dependent her retirement was on the success of one company and one industry, but she would not take our advice, and we parted company. Shortly after our meeting, Nortel’s value started crumbling, and I couldn’t help thinking of this person. I hope she took my advice and sold even a small portion of her Nortel position.
I use the Nortel example to hit home the need for rebalancing, but I could have chosen other examples of pain caused by over weighting and concentrating in one or very few positions. In fact, business owners also fall into the under-diversification trap, because they often have most of their holdings in the company they own and run. We constantly explain that reinvesting every dollar produced by their company may be a great investment, but if it runs into difficulties (for example, caused by a pandemic), a properly diversified investment portfolio will cushion the financial pain.
Here are four considerations when it comes to rebalancing.
Asset allocation
Every new client engagement begins with drafting an Investment Policy Statement (IPS), and we review the IPS of existing clients every three years. Part of the IPS is the formation of the client’s overall asset allocation.
The asset allocation is based on the client’s willingness, tolerance and capacity to accept risk. Although the three categories of risk sound the same, they are not.
1 https://en.wikipedia.org/wiki/Nortel
A person’s willingness to accept risk could be tied to their age. A 25-year-old may be much more willing to accept risk because they have time to recover if the market falls. On the other hand, a 65-year-old investor near retirement may not be able to recover from a market decline. Risk tolerance is more difficult to assess. Some investors may believe that during weak markets (such as March 2020); they will stay calm and might even add to their portfolio. But in reality, it takes every ounce of self-discipline not to panic and reduce or sell stock positions. Many investors don’t know their true risk tolerance until they have survived a bear market. Until then, we suggest assuming a more conservative asset allocation.
Risk capacity is mathematically determined. If an investor plans to retire in 2020 (against the Never Retire philosophy!), we can reverse engineer the investment return required to meet lifestyle expenditures. If the investor can withdraw their annual lifestyle expenditure from their portfolio with an investment of, say, 2%, then they may not need to buy assets like stocks and can slant their portfolio toward conservative investments such as short-term government bonds.
Ultimately, a comprehensive analysis of the three categories of risk will determine asset allocation. For this article, I will assume the investor has selected a portfolio of 60% equities and 40% fixed income.
As the value of the stock and bond component goes up or down, the actual asset allocation will move away from its starting position. In the IPS, we state that rebalancing a client’s asset allocation occurs when an asset class changes by +-10% . In our example, if actual asset allocation moves to, say, 50% equities and 50% fixed income, our review process will flag this and force a rebalance: sell 10% of fixed income and buy 10% of the equity component.
Note, sometimes the investor’s situation changes, and a new asset allocation should be selected before rebalancing is engaged.
Individual stock positions
In addition to the macro rebalancing, we believe that individual stock positions should be kept in a tight band. For example, if CNR goes up in value and represents more than a 5% weighting in an investor’s equity allocation, we suggest that this position be reduced/trimmed down. Again, we recommend investing the proceeds into a stock that has declined in value and is below the 5% weighting.
Since we limit each equity position to a 5% weight and trim down when this is exceeded, our process prevents one stock from ruining our portfolio. Even if one stock goes to 0, we would lose 5% of the equity position. If our asset allocation was 60/40, our total portfolio would drop by 3% – definitely a loss, but not disastrous.
We have been rebalancing investment portfolios for many years, and I have heard many arguments against this process. Here are the two most common.
Tax tail wagging the dog
The most common reason to question the rebalancing process is the tax ramifications of the selling transaction. In most cases, rebalancing causes a capital gain in the investor’s non-registered accounts.
Obviously, no one likes to pay taxes unnecessarily or prematurely. However, my investment philosophy is to maximize investment returns first and while keeping the tax consequences a low as possible – in this order, always.
Hence, if the investment model triggers a SELL, or if the asset allocation is more than 10% from the target, or if an individual stock is over weighted, we will place a trade to correct the imbalance and worry about the taxes later.
Please don’t misunderstand me: we are concerned with taxes. But we are more concerned with the investment returns.
Our favourite method of mitigating the taxes caused from rebalancing is called tax loss harvesting. This means that we may sell a portion or all of our underperforming stocks before the end of December and buy them back after waiting the necessary 30 days.
Reversion to the mean
Many investors are reluctant to sell or reduce a winning position and invest funds in a stock that has not performed as well. I am often asked, “Why are we selling our winners and buying a loser?”
Investors tend to extrapolate from what they have gotten in the past. As result, when a stock market is increasing, investors expect the trend to continue. However, it is likely that the price of the market is “discounted” or “priced in.”
For example, most investors feel more comfortable buying a stock after it has posted a good investment return, despite being more expensive from its historical perspective. In addition, investors often consider stocks that have not gone up in price as poor investments, even though they may be historically inexpensive.
Selling off all or part of those stocks that have done better than average and buying enough of those positions that have done worse than average in order to return the actual mix to the target mix will likely both raise returns and reduce risk.
In conclusion, we have back tested our models with and without rebalancing (trim up/down) and found evidence that the long-term returns are stronger when we rebalance as indicated above. This is why we will continue our practice of balancing our client’s portfolios.
Did this article resonate with you? What did I miss? Send me a note and let’s start the conversation.
The process of finding an Advisor can be overwhelming. Our process is designed with you in mind. Its structured framework helps you make an informed decision about engaging an appropriate advisor.
Call me if you in want to map out how you can Never Retire. You can also subscribe to our Never Retire Newsletter, contact us to order a complimentary book, register for one of our events, and call us to meet with a Certified Financial Planner. We offer you a range of services from a financial plan to investment advice or helping you take advantage of our investment models. Call me at 416.355.6370 or email me at richard.dri@scotiawealth.com.
1https://www.all-greatquotes.com/too-often-we-dont-realize-what-we-have-until-its-gone
source https://richarddri.ca/why-you-need-to-keep-rebalancing-in-mind-at-all-times-and-how-to-do-it/
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