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Even the most smartly constructed portfolio usually needs rebalancing at least once in a few years. Unless you could just buy one and only one stock, such as Berkshire Hathaway (NYSE:BRK.B).

Most portfolios require reallocation more often, usually once a year at least. Usually, this is either because a share of a specific asset class has grown above and beyond our maximum acceptable share on the portfolio, or because a specific stock has exceeded our maximum allowed share of one position on the portfolio. Another case when we would naturally rebalance is when we receive cash from dividends. A decision needs to be made whether to reinvest the dividend into the same stock, reallocate to a different stock or another asset class, or take the money off the table and find different uses for it outside of our portfolio, such as retirement income.

How do we make this rebalancing as smart as possible? The following are some of the tricks I use.

1. Use Of Dividends For Natural Reallocation

A dividend can be reinvested into the stock which generated it, often with an option of an automatic dividend reinvestment plan. However, a dividend can also be actively used to buy stocks and asset classes that have the best price-to-value proposition at the time the dividend payment becomes available. In actively using all dividends to purchase and not purchase assets that our portfolio "needs" in order to stay balanced, we can reduce or even eliminate the need of any deliberate rebalancing adjustments of our portfolios.

If, for example, the value of some stock in our portfolio is reaching dangerously high levels, or unacceptable levels in our own opinion, we will not reinvest the dividend into such stock. Instead, we will deploy this free capital elsewhere where it will bring a higher return on investment going forward.

Using dividends to rebalance your portfolio instead of selling stocks has another major advantage. Stock purchase does not trigger a capital gains tax event, whereas selling a stock might carry a tax event if held for less than one year in a taxable account.

Automatic dividend reinvestment inherently pushes our portfolio out of balance over time because, naturally, the highest amount of new dividend income will stem from the most successful investments, leading these to gain share on our portfolio. This can be great, of course - until the stock makes up a dangerous percentage of our portfolio.

One last, but very important benefit of active dividend management is that it gives me and other investors a periodic joy from having the opportunity to make new investment research and buying decisions. Simply put, active dividend reallocation is like playing golf instead of watching it on TV. It is like eating Swiss chocolate instead of owning Swiss gold and watching others eat the chocolate.

However, let me firmly state that from the investing point of view, there is nothing inherently wrong with automatic dividend reinvestment plans, unless the prices of the stocks purchased are highly overvalued. If you are not in need of rebalancing, or you simply want to manage your money more passively and use your spare time differently, that's perfectly fine not only for you, but also for your portfolio.

2. Cover Your Bases With Covered Calls

The second smart and natural way of rebalancing your portfolio can be found in covered calls writing.

The strike price of the calls should be chosen to reflect a level at which you consider the underlying stock to be severely overvalued and ripe for selling. In such case, you would sell calls on the entire position. If the calls expire worthless, it means that the price of stock has not reached levels at which you should be concerned that the stock is overvalued, and you bank the call premium as an extra income. If, on the contrary, your calls get called away, the stock has apparently reached the price level at which you were willing to ditch it anyway. In effect, you will be deposed of the stock while keeping the call premium for an extra profit.

3. Cascading Covered Calls

On the other hand, if you just want to trim your position because at a certain level it would breach your maximum portfolio share level, but you are fine with the current stock valuation, you might want to write calls on just that part of the position which you would need to sell in order to stay within your portfolio limits if the stock reached a particularly high price level. You would sell a small part of covered calls at higher and higher price levels, as you would need to sell more and more of the stock if its price has reached that maximum level.

Let's take an example. I am holding 3M (NYSE:MMM) stock, which I announced I would be gradually buying between May and October 2013 because it is a dividend king that has paid dividends for 97 years nonstop. 3M is currently selling at around $107 per share. Should the 3M price rise all the way to $135 per share by the end of this year, I would consider the stock overvalued - so, I would want to be fully out of the position at $135. Moreover, if the price rises above approximately $110, 3M would breach my limit of how much one stock can represent of the overall portfolio. What I can do is sell covered calls expiring in January 2014 at different strike prices, starting at $110 and going all the way up to $135 in $5 increments. At options expiration, this structure would "kick" me out of the position gradually as the price rises, exactly as I need it for my rebalancing.

I can currently sell the January 2014 $110 call at $3.80 and the $135 call sells for just a few cents. If I add up the prices of all strikes, I can get an average of around $1 per call, all fees and bid/ask spreads included. This option premium represents almost 1% of the stock's price. So, if the calls expire worthless, I would improve my return on 3M by 1% p.a. This sounds low, but compared with the current average S&P 500 dividend yield of 2.1%, this is a 50% income increase, while still keeping room for a maximum upside in stock price appreciation acceptable by my portfolio rules.

4. Use Asset, Sector and Seasonal Fluctuations

One more option to use for smart and profitable portfolio rebalancing is taking advantage of asset rotation, sector rotation and winter/summer seasonal anomalies. These topics have already been extensively covered in the articles above.

Conclusion:

To summarize, dividends can be used as a smart and natural way of rebalancing your portfolio without the need to sell any of your stock holdings.

The major reason why I prefer active dividend reallocation to passive automatic dividend reinvestment is that it gives me the freedom not only to naturally rebalance my portfolio, but also to use any dividend income to invest in the assets and stocks that I consider to be the best buy at that moment.

In addition to using dividends for smart portfolio rebalancing, there are at least two profitable ways of using covered calls. The first is to sell calls on the full position at a strike price at which you would deem the stock severely overvalued, and would want to close out of the position. A second option is to sell calls on parts of your position only, at increasingly high strikes based on how much of your stock position would need to be trimmed in order to stay within the safe limits of your portfolio allocation rules.

Most importantly, remember to play some golf and eat some chocolate while you count those Swiss gold bars and dividend checks!

So, how do you rebalance your portfolio?

Source: Smart And Profitable Ways To Rebalance Your Portfolio