A 20-70-10 Rule (P: MJG)

Hi Guys,

Most portfolio wizards recommend rebalancing a portfolio at least once each year to squeeze incremental returns into long term extra wealth. There are many ways to satisfy this requirement. Here is my approach.

Recall the famous 80-20 rule. It is often cited in all kinds of human endeavors, encounters, and interactions.

From Wikipedia: “Business-management consultant Joseph M. Juran suggested the principle and named it after Italian economist Vilfredo Pareto, who observed in 1906 that 80% of the land in Italy was owned by 20% of the population; he developed the principle by observing that 20% of the pea pods in his garden contained 80% of the peas.”

Simply put in an economic framework, 80-20 states that 80 % of a firms output is typically generated by 20 % of the workforce. If true, a reasonable action might be to greatly reward the productive 20 % while simultaneously firing the laggard 80 %.

Once again, incentives not only matter; incentives matter greatly.

In his 2001 book “Jack, Straight from the Gut”, Jack Welch introduced a variation of the 80-20 rule when proposing and implementing an incentive reward system for the company he captained, General Electric. He incentivized his workforce with a 20-70-10 yearly review program. He awarded outsized bonuses to the top ranked 20 % of his team members, gave modest cost-of-living rewards to the bulk of his staff, and fired 10 % of the non-productive cohort.

That strategy was easy to execute in its early years after inception, but became progressively more difficult each succeeding year as the firm’s deadwood were systematically eliminated. But Welch ruthlessly demanded that the rule be faithfully completed. This pruning operation was one of the reasons that Welch was saddled with the Neutron Jack sobriquet that he hated and has endured for decades. In the long-run this somewhat brutal tactic did improve the quality of the GE staff and likely contributed to the company’s success story.

The 20-70-10 rule can be easily mapped into the portfolio rebalancing task and the decision tree function in the investment universe. Think of the 20-70-10 rule as a general buy-hold-sell ratio for your portfolio holdings. However, I recommend using it as a guideline, not as a mandatory absolute rule such as employed in Jack Welch’s GE world.

From my perspective, since I am a long term investor, collecting data over an extended timeframe is mandatory. In my case, recognizing my trading infrequency, I deploy a 3 to 5 year data collection time span. The data assembly period must be matched to the anticipated trading frequency. A yearly trader need collect only weekly data inputs; a day trader needs data every few minutes. Preferably, do the scoring over a time period that includes both upside and downside market performance.

Use Morningside data sets to score formally. The Morningstar Risk and Rating statistical data sets are very comprehensive and have added depth and needed complexity over time. These data now incorporate separate downside and upside ratings in addition to a panoply of useful Modern Portfolio Theory (MPT) assessments. The evaluations include data from one year to fifteen year timeframes. Use these data to make more informed buy/hold/sell decisions.

However, I endorse a less rigid methodology. Base a final decision on a more informal approach that embraces diversification, non-correlation asset, and cost considerations. Gut feelings have demonstrated their survival worth in many instances during our lifetimes.

The final decision could be made solely and mechanically based upon a set of rules that are precisely defined and executed. In this manner, emotion can be excluded from the decision process. However firmly I rely on data assembly, I do not want to eliminate instincts and reflexive actions entirely from the final decision event. Gut reactions are an important component of the decision-making and should be judiciously integrated along with data intensive reflective considerations as part of the overall process. Rules and data serve as guidelines and are never Gospel.

I have applied the 20-70-10 guideline for several years now in my own portfolio management. As my portfolio grew to the multi-million dollar level, I added mutual funds and ETFs to further diversify and to serve as a risk mitigation tool. I typically include over 20 components to my portfolio with about two-thirds of that number (not total value) in equity positions and the remainder in income units.

My rebalancing strategy when coupled with the 20-70-10 rule encourages me to sell at least one fund each year while shifting a little more weight (the performance bonus mostly does this automatically) into the more highly regarded funds. This is not strictly a superior returns assessment, but directly incorporates other less rigorous judgment factors such as management stability, trust, and discipline into the mix.

I believe this process has tilted my portfolio towards a stronger total portfolio and has incrementally added some Alpha (excess returns) to its performance. You might consider giving this approach a test run when managing your own portfolio, or a part of it.

All successful leaders have integrated gut instincts with careful study and persistence to achieve their goals. Those same characteristics are needed to successfully manage a comprehensive portfolio. As Peter Drucker famously said “Management is doing things right; leadership is doing the right things.” So just do it.

It is always fun and mostly inspirational to close with a few quotes from Winston Churchill. This submittal is no exception. Churchill famously remarked that: “However beautiful the strategy, you should occasionally look at the results.” And “Success is not final, failure is not fatal: it is the courage to continue that counts.” Amen to that.

As always, your comments are encouraged and appreciated.

Best Regards,

MJG