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Ask The Analyst, Sunday, 01/25/2004

Rebalancing act
By Jeff Bailey

I read with great interest your ask the analyst column from Dec. 28, 2003 regarding the rebalancing of a portfolio. I don't watch the markets on a daily basis and hold a mix of mutual funds, a few individual stocks and like to buy longer-term call options with some of my risk capital.

I was rather shocked when I sat down and reviewed my various accounts this past weekend (getting ready for taxes) when I saw just how much things had changed! For the better I might add.

Unfortunately, I think, I didn't rebalance right at the beginning of the year, and a precious metals fund I own has given back some gains. Still, the way my other equity funds have done, it looks like I was still able to offset some of recent decline in my precious metals fund.

Will you be updating that article, or your benchmark portfolio? I'd like to see how things have done.

I was also wondering...

It has been just about 1-month, or 1/3 of a quarter since that December 28th Ask the Analyst column titled "Rebalancing Makes Sense," and while the question was asked more than a week ago, I wanted to wait at least one month to allow some time to pass before reviewing what has taken place.

Let's quickly look at what the rebalanced portfolio looked like on the December 26, 2003 close, and quickly review what an investor, or even an institutional money manager may have been doing just before the end of the year.

Beetle's Balanced Benchmark - 12/26/03 Close (Rebalanced)

As a quick review, what we were looking to do is simply bring our various asset classes back into balance. The #shares column with red boxes around those asset classes reflected the partial selling of those assets (which prior to the rebalance were then over weighted on a Value basis) and the capital raised from that selling, was then redistributed to the #Shares column and asset classes with the green box. At the far right of the portfolio, you can see that the Values of each asset class were just about equal, and rebalancing was complete.

Please note. This is NOT a recommended asset allocation. The equal distribution of capital is used to simplify the tracking of how each asset class is performing over time, and any impact seen on the TOTAL VALUE of a portfolio versus one that isn't rebalanced.

It is also important to try and understand "RISK MANAGEMENT" with what was done when rebalancing. What did an investor do when they sold some of their equity positions (DIA, SPY, QQQ, $HUI.X) which had risen 19.35% from 12/31/02 to 12/26/03, and also sold some of their corporate bond holdings (LQD) and junk bond holdings (PHF), and with those funds bought U.S. dollars (dx00y) which might represent cash you hold in an emergency fund, but may gain/lose purchasing power for foreign goods and services, shorter-dated Treasuries (SHY), intermediate-term Treasuries (IEF) and longer-dated Treasuries (TLT), where these Treasury bonds are backed by the full faith a credit of the U.S. Government?

While Treasury bonds will fluctuation in price and can have the investor gaining/losing money after purchase, this asset class is backed by the full faith and credit of the U.S. Government. Corporate bond are backed by the underlying company (if the U.S. Government goes bankrupt, chances are corporate bonds won't be much safer, and if corporate bonds were to default, then the company's stock would be worth little as the company would be in bankruptcy).

Here is a comparison of the rebalanced portfolio above, and the same portfolio shown in the December 28, 2003 Ask the Analyst column if we had not rebalanced at all.

Comparison of Rebalancing (upper) vs. not Rebalancing (lower)

I has been 4-weeks since the article on rebalancing. In PINK, I've highlighted the "Total" of the rebalanced portfolio, and the "Total" for the same portfolio if no rebalancing had taken place. The percentage difference would show the rebalanced portfolio having under performed the unbalanced portfolio by $11.39, or .094% (does not account for dividends or interest received and commissions paid).

The BLUE boxes at the "Subtotal" of each asset class ($$ and Bonds) and (Equities) would still have the "riskier" asset class of equities as a whole outperforming $$ and bonds.

The RED boxes show those particular asset classes that have under performed in the past 4 weeks (dollar and gold stocks), while the GREEN boxes show those asset classes that have outperformed (junk bonds and large cap tech-growth).

Note: While the U.S. Dollar Index (dx00y) has declined -1.12% since 12/26/03, the hypothetical $1,192.91 would still be a cash balance in the account, but the 1.12% decline may be representative of the loss of purchasing power for foreign made goods and services, impact of inflation, etc..

As we can see, there can always be the trade off of risk management, which incorporates the discipline of rebalancing a portfolio from time to time, which may have the trader/investor selling some of their winners and buying a loser. It may also have the investor/trader buying a winner and selling a loser.

The trader/investor that asked today's question also went on to ask about how his longer-term call options, where risk capital was used to buy various stocks might be classified in the scope asset allocation.

I have some general ideas on that part of the question.

I always try to think in very generic terms, and try to think of a stock as it might related to it representation of a major index, or even an industry, but only in the concept of top of mind awareness. Or word association if you will.

When I say Intel (NASDAQ:INTC) what do you think of?

I think... large cap technology.

While Intel is a component of the Dow Industrials (DIA in the portfolio), the S&P 500 (SPY in the portfolio) and the NASDAQ-100 (QQQ in the portfolio), I'd think of a longer-term call option as a portion of a QQQ asset class.

When I say Merck (NYSE:MRK), which is also a Dow component and S&P 500 Component, I tend to think MRK as more of an SPX asset class, where the company is more focused on drug manufacturing.

Johnson & Johnson (NYSE:JNJ), which has its fingers in everything from consumer products to drugs to healthcare equipment, I might also think SPX asset class. However, if I owned a call option in MRK, then I might make the exception and say JNJ is now a Dow representative, and count it toward my Dow asset class.

So... there's a quick update on rebalancing in what I would consider to be a "real life" example, which we can continue to test over time.

What are your investment friends saying these days about valuations of stocks?

Have you heard from any of your overly pessimistic friends this month that told you at this past year's holiday party to dump all your technology stocks and buy gold stocks?

Has your next-door neighbor been letting his dog frequent your front yard of late after you told him to dump everything he owned and stuff it in his mattress? Or has your neighbor brought you homemade bread only because you told him to re-balance his portfolio and he feels like he raised a little cash in his account, and can't wait to rebalance next quarter and snap up some bargains in the precious metals sector?

Jeff Bailey

This column is an information service only. The information provided herein is not to be construed as an offer to buy or sell securities of any kind. The Ask the Analyst picks are not to be considered a recommendation of any stock or option but an information resource to aid the investor in making an informed decision regarding trading in options. It is possible at this or some subsequent date, the editor and staff of The Option Investor Newsletter may own, buy or sell securities presented. All investors should consult a qualified professional before trading in any security. The information provided has been obtained from sources deemed reliable, but is not guaranteed as to its accuracy.


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