How Do Investors Know When It's Time to Rebalance Their Portfolio?

Regardless of your investing style, most investors need to rebalance their portfolio from time to time. And in today's market environment that is fraught with high volatility, you're not alone if you're considering what companies might be the best use of your capital and what areas you might need to trim in your portfolio. In this segment of Backstage Pass, recorded on Dec. 13, 2021, Fool contributors Jason Hall, Rachel Warren, and Toby Bordelon discuss. 

Jason Hall: I look at this as an example, and I want to be clear here, I'm not calling out Microsoft as a company that I necessarily think is overvalued, but today Microsoft trades for almost 15 times sales. That's over the past decade, that multiple has just gone up and up and that correlates largely with its share price increase, I think that's important.

Guess what though? Its operating margin has also largely gone up over the same period. Is as it's built up its cloud services business. It's moved more to software-as-a-service and less selling boxes of software and then having an upgrade cycle. There are reasons that that's gone up.

But at the end of the day, if you stretch this out. Let me pull the operating margin number off, its operating margin has been relatively high in the past. But where's the truth of the valuation, is what I'm trying to figure out, for this 40-year-old company, where is the value really, and is it going to be here or is it going to be closer to eight to 10 times?

That concerns me because we've seen a period of time where some of these highly valued companies that were very large and very profitable have gone through this. This is an extreme example with Microsoft. This is from the end of December 1999, late 1999, the stock hit its all-time high. Over the next four years, Microsoft grew its revenue 76%.

Earnings were down for a while, this is going through the recession of the early 2000s. But at the end of that period its earnings were higher, its revenue was way up, the stock price was still down by half.

I'm not making any predictions, guys. I want to be clear. I'm not making any predictions at all. But how long is the market going to continue to view Microsoft as being worth 15 times sales. Even as it continues to grow sales and earnings at the rate that it's at as large as it is. What's going to look like in five years?

I start thinking about the larger market, those indexes with the Microsofts and the Amazons and the Apples that carry so much of the weight of the index.

If at some point the market is not going to value them at these high multiples, it's going to weigh on the broader market, and it's going to affect the multiple that people are going to be willing to pay for CrowdStrike, too, at the end of the day. If they're not going to pay a premium for Microsoft, they're not going to pay a premium for Zoom, Zscaler, a lot of these other great businesses that we love. 

I'm just being meaningful and thoughtful about that and the last thing I want to say on this is. I know I have said a lot already, but I just want to say this. It's got me thinking about something that I heard Tom say earlier this year and it's one of the biggest questions that he continues to try to figure out how to answer.

That's when you have companies you own and love, they continue to do wonderful businesses, that you've invested in for a very long period of time, and it's been a magnificent winner for you, life-changing results. It gets to the point where it now makes up a meaningful portion of your net wealth.

The numbers that Tom put out there is like it's 20% of your net worth. Not 20% of your retirement account, but 20% of your entire net value. Then do you have to start thinking, even if I love this business, even if I like its prospects going from here, I have to start thinking about how unforeseen circumstances could affect my quality of life, could actually harm me materially from here.

I think a lot of investors really need to be thinking about that that have let the Apples or the Microsofts or the Netflixs of the world they become enormous winners and they've done what they bought them to do.

But now the downside exposure that these individuals have, so, so much of their net worth in that one business, in an environment we have right now where multiples are far and away far higher than they've historically been, you just have to be meaningful about that. That's where I am. Did I say that well or was that like fear-mongering?

Rachel Warren: No, it was good. I would add to that that's why I think it's so important to rebalance your portfolio from time to time. Because you may, for example, allocate capital equally to X amount of stocks, but those stocks aren't all going to grow at the same rate.

If you find that your portfolio is overly dependent on a particular stock or stocks, especially in these market times, it might be good to say, "OK, where do I need to maybe allocate a little extra capital," or you know?

Hall: That's a good way to put it because sometimes you think of rebalancing is like, well, I need this stock is now 10% of my portfolio, it needs only be 5%. That doesn't mean you sell it.

That means maybe you just invest new capital in other places, or trim your weeds, those underperforming businesses. 

Warren: That would be my approach yeah.

Hall: Then reallocate that cash into some of your other winners.

Warren: Absolutely.

Hall: Yes, that's great. Toby.

Toby Bordelon: I don't think I have much more to add to that, but I wouldn't say it's fear-mongering. I think it is just being aware of what might happen.

I will say, look, let's use your example. Let's assume that the market only at some point in the future is only willing to give 10 times sales to Microsoft, let's assume Microsoft doubles sales by the time that point happens, you still make money, right?

Hall: Bingo, exactly.

Bordelon: But I think you've got to approach that with the right mindset. You can still make money, but are you going to like 3x your money in that scenario? No, you're not. It is a balance. Set expectations properly, I think.

Hall: Those expectations, you need to invest according to your timeframe, right?

Bordelon: Right, right exactly.

Hall: That's hugely important. If you have X amount of money that you need next year, stocks are not it. Even if it's the best growth company in the world, even if it's a stalwart, you just don't know what could happen.

Right now today, in 2019, do we have any idea where we were going to be on March 23, 2020? We saw the market lose 35% of its value in a month.

Warren: That's why I think you've also got to take some of these predictions with a grain of salt. It's good to weigh them and see how that might impact what you're thinking about investing as we approach the new year.

But the truth is, no one knows for sure. We can look at the market and see what those indicators are, but we just don't know.

I'm hopeful for sure going into the new year, I'm not worried or afraid, but I think that if you're more concerned, it might be a good time to see where some of the more risky investments are and balancing those out a bit.