Is a perpetually balanced portfolio feasible?

[NickMPK]

Just for background, I know very little about stock trading, but have a few stocks and mutual funds that I was given as gifts a long time ago and have held up until now (now worth about $50K).

I was recently reading Poundstone's "Fortune's Formula" where the author discusses Claude Shannon's idea of a perpetually balanced portfolio as a way of maximizing returns.

The idea behind this is that one chooses a certain number of investments in certain proportion, and keeps these investments balanced in the same proportion (in term of $ worth of each investment) no matter how each individual investment moves.

For example, one might choose 50% cash and 50% Microsoft stock. If Microsoft goes up, you sell some of it until your cash equals the value of the stock. If the stock goes down, you buy some more until cash = stock. According to Shannon, this makes use of the Kelley criterion to maximize your compound returns (I'm drastically simplifying here).

This idea appealed to me because it seemed like a way to get a reign on the risk in my portfolio (which has recently become heavily weighted toward Apple stock) while still earning good returns and not requiring me to try to out-think the market. It also occurred to me that I could include my poker bankroll (I am not a pro, but earn probably 1/4 of my income from poker) as part of the balance.

The book mentions that Shannon never implemented this theory because he thought that taxes and transaction costs would eat away any benefits. But I don't know if the same would be true now that trading online is much easier. Or perhaps if one just decided to rebalance at the end of every month (or some other period) the transactions costs would not be that high?

Has anyone implemented any sort of variation on this idea in their own investing, or have other thoughts on it?

[investormcgee]

This idea is used constantly in today's investment world. Investment advisors sell this idea to clients as the only way to go when investing. With constant re-balancing it gives you a decreased amount of risk and typically a more stable (sometimes better) return.

[emon87]

Most people just rebalance every year or at most every six months. Doing it any more than that would definitely result in transaction costs eating up at your entire gains (if it is even better). Even if you used a free broker, you would still trigger a bunch of capital gains taxes. Some of these would inevitably be short term, which are taxed at a higher rate than long term. This would be avoided by doing this only in a retirement account.

But even if you were doing it in a tax advantaged retirement account with a free broker, I really don't think it would be worth the hassle. Just do it every six months or one year.

[DcifrThs]

[ QUOTE ]
This idea is used constantly in today's investment world. Investment advisors sell this idea to clients as the only way to go when investing. With constant re-balancing it gives you a decreased amount of risk and typically a more stable (sometimes better) return.

[/ QUOTE ]

the real world deals with taxes though and transaction costs. studies have examined rebalancing with and without these considerations. monthly rebalancing is sufficient to earn the additions to a passive portfolio's sharpe ratio while minimizing the costs associated with it.

this is similar to hedging considerations of an int'l equity portfolio. while in a vacuum, 100% hedge is optimal, when transaction costs are taken into account a 50% hedge becomes closest to optimal.

Barron