Description

Mental Models discussed in this podcast:

• Modern Portfolio Theory
• Compound Interest
• Rebalancing
• Beta / Volatility

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode64

Modern Portfolio Theory

• According to Investopedia: Modern Portfolio Theory definition 

Modified Doubling Penny Example

Three scenarios are compared: 

1. Base Case Compounding
2. Diversified Portfolio
3. Diversified Portfolio with Rebalancing

It is a mistake to rebalance from an investment with high return potential into an investment with low return potential.

• If you are going to sell an investment that is up for one that is down then you should be confident that the lower cost investment actually offers a better return.
• Don't trade 10% return expectations in stocks for 2% return expectations in bonds.
• Betting on future volatility to allow you to rebalance back again is gambling not investing.

Summary:

Rebalancing is an often mentioned tactic utilized in modern portfolios but seldom is it examined from first principles. The act of rebalancing can be useful to offset volatility amongst assets within similar return profiles. However, rebalancing between assets that differ in potential returns can lead to disaster. Compounding requires the ability to earn interest upon interest. If you rebalance away from the compounding asset, then you will counteract the powerful effects of compound interest.