Rebalance or not to?

[apine]

nodoodah, i just don't like that you question tomsmith's value as a trader in your post because he considered bankruptcy a possibility in his trading strategy. and then, later on, you say that whatever trading strategy you have would have gotten out of such a stock a long time ago via stop loss (or whatever).

[doctorwes]

Getting back to the original question: Surely the optimal portfolio weights are not equal, or even constant over time, but will vary with your current beliefs about the joint distribution of returns of the stocks in question, and in particular will depend on the expected returns of the individual stocks. I would have thought as a company descends into bankruptcy, you would eventually revise your expected return on that stock, leading to a reduction in the optimal weight, probably to zero; and this would prevent you from doubling down indefinitely. If your investment strategy does not have that property then, as apine suggested, it may not be a prudent one.



This paper is worth a read. It contains a cautionary observation about rebalancing strategies with good theoretical properties.

[nodoodahs]

Back to the original subject, to rebalance or not, and how to allocate amongst stocks.



My input is TEST IT. Run the strategy results with a variety of backtesting and position-sizing algorithms and see which one(s) generate the best risk-adjusted returns, with the metric of your choice. If the concern of "going to zero" while being held is legitimate, in terms of your system design, one could adjust for that through various technical or fundamentally quantifiable metrics, selected through analysis of past "gone to zero" stocks. One can never completely eliminate risk, including the risk of ruin, but one can take reasonable steps.



The MPT links are good stuff, but one might also consider volatility-based position sizing on equity positions, maybe based on bollinger band width or some average true range multiple. Think also about varying bet size as a constant risk percentage of equity.



Now continuing the discussion with apine, which is hard to do, since it keeps getting edited and more responses applied. I'll do my best. I apologize to any late members who may see a response to something that apine deleted in an edit, or may not see a response to something apine added after I last looked. Hell, this response has been edited!



I didn't make assumptions about the strategy that were independent from bankruptcy odds; I did make the explicit statement that trading strategy *must be considered for bankruptcy odds to even be calculated accurately.*



I never questioned anybody's value as a trader, I just expressed concern that someone was speaking out of fear instead of calculating odds and trading based on them. Everybody's got fear, it is merely a question of whether we express it through our trading, or not, and whether it's a rational fear, or not. Without knowing the strategy involved, I can't know if it's a rational fear, but I would suspect that for most diversified and well-constructed equity strategies, it's not a rational fear.



It's a shame you took offense, because none was offered. Trading *is* probably a bad arena to act out fears in. Perhaps you're an exception, apine? I would venture that far more traders have wiped out from emotionally overreacting to market events than from emotionally underreacting to market events through the continuation of a well-devised and tested plan.



If you think an attitude that involves attempting to dispassionately trade according to a semi- or totally mechanical plan, leaving all (or at least most) of the discretion in plan design and none (or almost none) in the execution, and ruling out the input of fear, is somehow a *bad* or *offensive* attitude, perhaps we should agree to disagree.



Your love of my ignorance for ridiculing the MSFT/XOM trade doesn't change the fact that I hold spurious correlation trades in a general state of ridicule, and that idea in a high state of ridicule. I could see those trades being less ridiculous under some conditions, i.e., high frequency of trades, mechanically implemented, combined with a continuing evaluation of trade results to confirm the system is working according to plan.



Your observations of people wiping out waiting for a mean to revert have more to do with poor system design on their part, than it does with their emotional control, or lack of same.



Nothing helps with fraud, other than getting out of an equity when company fraud is disclosed. Has any company ever gone to zero in a day, as a result of fraud, without giving a manager of a liquid position the opportunity to exit? That's your risk of fraud, and I submit that it's a lot smaller than you appear to think it is. Again, you have one example out of the multiple tens of thousands of listed equities being traded over multiple decades? What are the odds, and how do they figure into a plan?



WTF does naked put selling have to do with the price of tea in China? You're confusing two different risk issues, one being the payoff histogram of a strategy, and the other being solvency risk of a company. I would venture that a diversified portfolio of naked put sales had more at risk from a market correction impacting ALL of their positions, than it would from a bankruptcy and fall to zero in any ONE of their positions, so it seems you're lumping diversification risk in your analysis as well. So I see three different issues being, IMO, inexplicably being combined.



I manage my own money, which isn't much, and most of the board participants probably pay more in annual commission than I manage. I would venture that I care very phucking deeply about the money I manage, and I'm not very concerned about any company whose stock I trade going bankrupt or to zero while I'm holding it in any one of my diversified quantitative strategies. I think there are larger risks involved than one company going bankrupt or to zero while I'm holding it.

[DrTarr]

Apine,



Dude sorry if I Angry .



My point is for the OP who is I beleive buying stocks - not naked puts; and so I should be more careful in my wording about "any" strategy.  My position, which was reiterated by DocWes is continuos montioring and evaluating the positions.  As they go down hopefully some rational thought might kick in before reaching the big egg!  Yes, bad news happens and stocks can go down rapidly.  But split up your money according to the expectations you have, and the diversity you need to sleep and watch it.  But in a choice to rebalance or not, the fear of going to zero should not be a driving factor, the reality the position may go down certainly.  If he has a poitive return expectation and is worried about it going to zero, then perhaps stocks ain't his bag!

[apine]

you miss the point. you can call me chicken all you want. i dont care. the reason i edited was because i said something that i thought you would take offense to and no one had replied yet. i hoped that no one had seen it yet. that's all.



but anyway here is my last post on this part, plain and simple:

1) merely because it did not happen before does not mean it won't

2) you can do your data work all you want. very hard to weed out survivor bias

3) odds are great but no point in leaving yourself exposed to unlikely but catastrophic issues (on this part we agree)



i have been trading options for a long time. and the catastrophe puts were what i was referring to (like a $5 or $10 put on msft). to put the way you do: i can hardly see a market scenario not involving msft directly that will take it down to $3. and no matter how unlikely the scenario, traders that last tend to try to cover their wings.



well, it totally disagree. if someone said this to me:

I'm concerned by the psychology of your example, "what if" the stock falls to zero. How many stocks ever fall to zero? What percentage of stocks do they represent? Is this a realistic concern for the stocks that you are trading, during the timeframe you intend to hold them, or is this an emotional fear trying to express itself in your trading? The market is a good place to find out about yourself and how you handle fear, but it can be an expensive proposition.



then i would think they are addressing my value as a trader. just like when you try to insinuate that i am doing something shady by editing the post and that i "act out my fears" trading. i'm not sure what that means. i know that my fear guides me to cover my rear end so that i always am able to start the next day in business. and to consider bankruptcy, fraud or takeover risk when trading options in single stocks. because contrary to your indication, it DOES happen. it need not happen frequently. only once to your position.

[apine]

DrTarr and nodoodahs, none really taken. (ok i already violated the post thing). i know what you guys mean. and i understand that one wants to take positive expectation bets. and i know both of you get the idea of integrating the possibility of bankruptcy into the strategy.



but this is not an irrational fear. companies DO kick the bucket and crater in a couple of trading sessions. i'm not saying don't do the trade. i'm just saying be cognizant of it. and don't call someone psychologically disabled for trading because he is considering it. particularly since this guy is talking about incorporating it into his strategy just as both of you seem to have done so.



edit:

DrTarr is right. sorry nodoodahs if i came on too strong. not trying to pick a fight.

[Tradenator]

Back to the topic at hand, we rebalance whenever we close out of a position, and redistribute systematically across a group of contendenders in a set of entries.  We are either in a running position, out completely, or dipping our toes in entry positions.  To me, rebalancing is the process of sizing entry positions rather than something that is done across the board.  Exiting a winning position is more about that particular position than the rest of the portfolio, and you have to keep very aware of market conditions this way.



tomsmith, if you are intending to buy stocks and hold for a long time, you might want to read up on Warren Buffett, Benjamin Graham, etc.  Hell, maybe even buy Berkshire Hathaway shares and let them do the work for you.  What I've described is more about systematic trading with constant care and feeding.

[nodoodahs]

Buffett's a trader, with a good mix of short and long term positions.  He cut his teeth in special situations and arbitrage.  You can go to GuruFocus and see his disclosed holdings, and track them as they change.



Graham was a trader.  If you look closely at his "cigar butt" NCAV trading system, you'll see that it's pretty mechanical and totally quantifiable in nature, as were his "defensive investor" and "enterprising investor" systems.  The Intelligent Investor is a good book (get the recent one with expanded commentary by Zweig), even though he makes some pretty uninformed "straw man" arguments against technical analysis.



Time frame doesn't define systematic trading.  Traders can be quantitative system traders even with holding periods of one year or more.  Take a look at Joel Greenblatt's "Magic Formula Investing," in The Little Book That Beats The Market.  It is a purely mechanical and quantitative trading system, as presented.



The Graham systems and Greenblatt system all diversify equally amongst positions, if I remember correctly.  BG recommended something like 30 NCAV playes, and Greenblatt recommends around 25 or so positions.  I'm going from memory here, take it with a grain of salt, but they got around solvency risk through diversification, and solvency risk is a big issue with cigar butt investing.  I think JG addressed the rebalancing when positions were evaluated at one year's holding time, but I'm not sure.



If someone had come to the board and said, "how do I rebalance so that I don't overallocate to a position that winds up losing money?", I wouldn't think that any irrational fears were involved.  However, so few listed companies above the microcap range ever go to zero, that I think when a first post from a new member is addressing that possibility, it may be out of a fear that is ... less than rational.  Fear impacts my decisions all the time, and usually in a negative way.  That's not "psychologically disabled," that's human.  It's worth discussion, and it's not a negative, it just is.  It should be accounted for in system design, if possible, and if not, it should be expressed in some way outside of trading.  Otherwise, it gets expensive.  It's happened to me more than once.



Yes, companies go bankrupt, yes, we have to account for that, yes, just because it didn't happen in a nine-year backtest on a survivorship-bias-adjusted database doesn't mean it can't happen.  But!  Accounting rationally for a possibility means giving it the proper amount of free rent in your head, not a square inch too much or too little.  Fear of some event should have some direct relationship to the odds of it happening, and the consequences (in context of a trading plan, in this case).  I just think there are bigger risks to take primacy.  I could be wrong ...



Re: your editing, it's not about calling you anything or questioning your intent, etc., I've edited posts to remove content when I realized that I had exercised poor judgment or thought I needed to clarify or expand on a statement.  I mentioned the editing because I was responding to things that might not have been there later and might have caused confusion.  Matter of fact, I *did* think you were picking a fight with one of your pre-edit comments, and I responded (pre-edit, of course).  I thought better of it, and edited to delete.  I'm sorry for any contentiousness I may have caused here by my actions, I know I'm not blameless and I'm a bit of a social retard at times.

[Tradenator]

kr, following on your comments, I would suggest that there should be a measure of how well things are and aren't working, so you  know when to rebal/change tack.  For example, drawdown recovery time might increase over the long term average.  Your thoughts on this?



tomsmith, you still here?

[tomsmith]

Thanks for all your thoughts guys. I am not a quant, so it takes me time to get through all of the recommended reading.



Just to clarify, I am trying to minimize only the impact of price going down all the way to zero. (not price fluctuations)



Tom