10-04-2015, 10:34 AM
I have a rule that when a position becomes excessively overvalued, that the position will be rebalanced. Note that I don't rebalance due to a position being overweight.
The key was defining what is excessive. After much consideration, I decided a position is excessively overvalued when investing in another stock at fair value will result in more dividend income after capital gains taxes than staying in the original stock.
The actual point where a stock would be considered overvalued will depend upon the characteristics of the original stock and the replacement stock; however, I was interested in a rule-of-thumb, so some simplifying assumptions were made. First, the yield of stocks at fair value are similar and the yield varies inversely proportional to the ratio of the current price over fair value. Second, the error due to using the total value of the current stock for taxes is of the same magnitude and offset by the error in calculating fair value. With these assumptions, the following relationship was derived for the breakeven point:
Overvalue Price/Fair Value Price = 1/(1 - Tax Rate)
For long term, Pov/Pfv = 1.18
For short term, Pov/Pfv = 1.33
Assuming stocks are bought at fair value or lower, this results in selling due to overvalue being relatively rare.
The key was defining what is excessive. After much consideration, I decided a position is excessively overvalued when investing in another stock at fair value will result in more dividend income after capital gains taxes than staying in the original stock.
The actual point where a stock would be considered overvalued will depend upon the characteristics of the original stock and the replacement stock; however, I was interested in a rule-of-thumb, so some simplifying assumptions were made. First, the yield of stocks at fair value are similar and the yield varies inversely proportional to the ratio of the current price over fair value. Second, the error due to using the total value of the current stock for taxes is of the same magnitude and offset by the error in calculating fair value. With these assumptions, the following relationship was derived for the breakeven point:
Overvalue Price/Fair Value Price = 1/(1 - Tax Rate)
For long term, Pov/Pfv = 1.18
For short term, Pov/Pfv = 1.33
Assuming stocks are bought at fair value or lower, this results in selling due to overvalue being relatively rare.