Forget rebalancing – ditch your losers, not your winners

The FTSE Equity Investment Instruments Index, comprising investment trusts (whether invested in listed equities, unlisted businesses or other assets), returned 17.8% in 2020, after returning 21.4% in 2019.

But there was a huge dispersion within these averages. In 2020, the shares of three trusts more than doubled in value while 17 rose more than 50%. That’s rather more than the 11 which rose by more than 50% in 2019, when none doubled.

Many of 2020’s winners were building on long term success. For example, Scottish Mortgage returned 110% in 2020, having returned 136% in the previous five years and 444% in the previous ten.

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Faced with these sorts of gains, many investors wonder whether they should hold on for more – or take their profits while they’re ahead.

Here’s my view.

Rebalancing is comforting – but it can be a mistake

Many of those who have held onto investment trusts – especially growth-orientated ones – over the past few years, will now be sitting on large profits. They might well be wondering whether to cash them in, in whole or part. Elated by their fabulous gains, they will dread the possibility that those gains might slip through their fingers.

Advisers and wealth managers too will encourage profit-taking, as their clients will hate the thought of profits disappearing much more than they relish the prospect of further gains. If the price keeps on rising, the adviser was just being cautious. But if it goes down, they will look foolish and could be fired.

But is this strategy right? “Rebalancing” a portfolio by trimming the winners and topping up the laggards or buying “bargains” makes the portfolio look tidy. But it runs counter to the oldest rule of investment – run your winners and cut your losers.

“Nobody ever went broke taking a profit” runs the counter-argument, to which the best riposte is: “True, they went broke reinvesting in losers.” The case for taking profits in Scottish Mortgage may seem compelling – but the same was true a year ago, and indeed, at almost any time in the previous five years. Certainly, you can always buy it back if it keeps rising but buying back at a higher price is, psychologically, one of the hardest decisions to take.

This time, we are told by many grey-haired experts, it’s different. Growth stocks in general and technology stocks in particular are at the maximum inflation point of a “bubble,” comparable with 2000, as shown by the valuation metrics for electric car maker Tesla and the other new economy mega-caps of the S&P 500.

On a forward price/earnings ratio of 22.5, the S&P 500 certainly looks expensive. The p/e is approaching the 25.7 seen at the tech bubble’s peak. With higher margins and lower taxes, the price/sales ratio, according to Ed Yardeni, is 2.54 against 1.77. In all, 53% of the S&P 500, he reports, trades on a p/e ratio above 20.

Three key reasons why today is not the same as 2000

However, there are three flaws in such comparisons. Firstly, the yield on the ten-year US Treasury, though rising, is only 1.2% against 6% in 2000. So US stocks are not expensive relative to bonds.

Secondly, the tech boom of the late 1990s subsequently proved to be not a blind alley but the overture to a technology revolution. As MoneyWeek’s Dominic Frisby points out: “manias almost always accompany new technologies.”

Finally, the business models of many of the high fliers in 2000 soon proved to be deeply flawed due to leap-frogging technology, competition and over-investment. By contrast, in recent years, companies such as Peloton, Ocado and Tesla have faced deep scepticism, but have gone on to prove their business models. They may be over-valued, but they aren’t duds.

The counter-argument is that bond yields are only this low because of reckless money-printing which is sure to end up in inflation that will be painful to control. At its simplest, inflation can be described as “too much money chasing too few goods”.

In the pre-globalisation era of restricted labour markets and inflexible supply, that meant a spiral of rising commodity prices, wages and retail prices, but that may no longer apply. Now, perhaps, too much money just pushes up asset prices such as property, collectables, gold and equities.

If so, the real bubble may be yet to come, and we are now in the equivalent of 1998 or early 1999. Katie Potts, the manager of Herald Investment Trust, describes 1999 as “the most painful year of my life” as a result of short-selling tech stocks.

The clinching argument for holders of investment trusts is that the managers are doing the worrying and trading, if necessary, for you, and are in a much better position to judge the prospects and valuation of each investment. Over them stand the non-executive directors, constantly badgering them about the portfolio.

The manager may have had good luck to perform well, but is unlikely to be an idiot. How likely is it that an individual investor will spot something the manager and directors miss? It’s not impossible – anyone who read about Wirecard in the Financial Times should have sold European Opportunities Trust regardless of what Alex Darwall and his directors said – but it’s rare.

By all means take some profits in the market to finance holidays, celebrations, collectables, gifts and living expenses, but focus first on the losers, the dullards and the doubtful in your portfolio.