Two readers of this blog left couple of intelligent questions in comment section on some of the articles. Both of these questions relate to what I term as rebalancing the portfolio (or profit booking). I wanted to wait until I posted articles on TIPBlog portfolio update and risk analysis. I wanted to discuss these two questions in the context of TIPBlog portfolio. It will help better understand the re-balancing and profit booking processes.

You may have read earlier post that discusses risk analysis. I made a comment that the portfolio has overexposure on few stocks like ONGC, LNT, etc. I also mentioned that I will not be selling any partial shares to bring down allocation. Many use the term profit booking for partial selling.

When investors are using equity for long term wealth (instead of cash in and out and focusing short term) then it makes more sense to understand the concept of capital allocation. In the capital allocation approach, the simple aspect is expected rate of return on the capital. Re-balancing or selling partial shares should be based on how much return does one expect on allocated capital. The concept of “profit booking” applies to brokers/traders and individuals who have short term orientation and focus of trading. It is not applicable to any of the long term value or wealth building strategies. Let us discuss this in the context of TIPBlog portfolio. The table below shows three companies and its return characteristics as measured by YOC, XIRR, and Life-to-date returns.

Rebalancing

For all three stocks you may see that (1) YOC are higher than original yield; (2) Personal annualized rate of return, XIRR, has been more than 15%; (3) Lift to date returns are in order of magnitudes, instead of few percentages.

For the sake of this example, let us assume that I will sell partial position, or book my profits. What will I do? I would sell 50% shares and take that capital. Let us say, now I would have Rs 1,00,000 profits. What should I do with this profit? There are two things I could do which are:

1. I could use it for personal use, expenses, buy something for my family, or go on exotic vacation. Basically, put it use for some expenses.
2. If I do not need it for personal use, I will need to deploy it again in some form of investing. Where will I invest? I would like to invest in an asset (i.e. real estate, stocks, etc) that I have confidence will give me maximum possible return. What would be point of investing in asset that gives lower return! Right?

In my strategy, I will have to re-invest because I am not looking to use these profits for my personal use. I will need to find an idea that will provide me returns that are higher or at a minimum somewhat similar. I need another idea or stock that I believe will have potential to give increasing YOC; XIRR that is higher than 17%; LTD returns in excess of 100% in less than 5 years, etc. Unless I find another investment idea, it is always better to remain invested.

In another scenario, when I perform the yearly review, and I find some signs of trouble then I may reduce the holdings or completely sell the stock. By signs of trouble, I mean it does not meet the criterion I am investing for or change in company fundamentals, etc. The example of this is my recent selling of GE Shipping. I bought it early 2009. When I looked at fundamentals of the company, I was not ecstatic about it. I sold GE Shipping position completely. I allocated that “full capital” to stocks of Hawkins Cooker. Note I allocated full capital not standalone profits.

Now that you understand the strategy of re-balancing, you can read some of my analysis I have presented on this blog. In my analysis, I always attempt to understand the expected return. One may ask how sure you are about the expected return. Well, that is a whole different subject. There are many different ways to estimate expected returns. Some use intrinsic value based, some use margin of safety based, some use company’s growth projection vis-à-vis PE ratio, some use CAPM based, etc. In my view there is no fool proof method to estimate expected return. It is always perception of risk vs. expected return.

I do not claim that my expected return will always be right. However, I use a particular approach with very conservative expectations. I like to put my risk perception and expected return in numerical values. I avoid pure subjective explanation of risk and expected return because I find it difficult to make a comparative judgment. I am hoping that such an approach will facilitate my long term wealth building goals. So far signs are it is working.