Evolving Selling Strategy, Part V
Tuesday, April 17th, 2007The Ideal
As prices fluctuate, earnings are reported, and economic events unfold, you must continuously re-value each affected stock, whether you own it or not, to determine the optimal portfolio. Your actual allocation must be continuously rebalanced to match the optimal portfolio. The impacts of commissions and of capital gains taxes are considerations that will reduce sudden changes in your allocation.
The Reality
This ideal is impossible to achieve, as it essentially requires modeling the entire economy. However, there may be a way to approach it.
A portfolio definition is nothing but a set of instruments (consisting of stocks and cash) and a percentage allocation to each. The percentage allocations are calculated from a large but finite number of quantities. Some of these quantities can be acquired in an automated fashion (like the price of the stock). Others can be acquired manually (like the earnings history for the company). Still others others are truly subjective (like the multiplier applied to an investment’s risk due to legal action pending against the company).
It is possible to recalculate a portfolio’s percentage allocations whenever any of these quantities changes, and it is possible to update these quantities on a frequent periodic basis (for example, daily). Indeed, for each instrument, a schedule or calendar can be established, specifying which quantities should be updated, when, and from what source. Furthermore, as it becomes apparent over time that certain indicators (e.g. interest rates) affect the instrument’s price, these indicators can be included in the risk/return model for the instrument, and updates to the indicators can be added to its schedule.
In the description above, a stock is dropped from the portfolio when its allocation drops to 0%. The trick is to enable the portfolio to pick up new stocks, assigning them a non-zero percentage allocation. However, I already have a well-defined process to take hundreds of mere tips and filter out the handful of rational investments. The process allows the set of rational investments to change, and the percentage allocations should be calculated only on this set.
There will be a difference between the portfolio that is currently owned and the portfolio that is currently optimal. This difference may be small, meaning that the rational instruments, their numbers, and their percentage allocations may be very close. The difference may also be large, meaning that very different instruments, in different quantities or percentage allocations may be optimal. However, what really counts are the commission costs and tax implications of making the transition. If the risk/reward ratio of the optimal portfolio sufficiently exceeds that of the owned portfolio, then it is rational to incur the costs and taxes.
Setting up real continuous portfolio optimization requires quite a bit of programming to automate, as much as possible, the gathering of information and quite a bit of personal discipline to manually gather the rest. However, it is the most highly evolved rational strategy I have come across to date.