This is what I will call the Carvalho Strategy after the person who started it all. I am not sure he started it, but I do know that it is the product of his fertile brain. Whether he internalised the strategy of someone else (ala Kavya of Harvard fame), I do not know!
The Carvalho Strategy is based on two basic facts:
1. Index stocks are likely to loose the least in a bear market.
2. Index stocks are on average likely to fluctuate in value by about 50% in a twelve month period.
Based on the above facts, the strategy involves investing in index stocks. Pick an index with at most 50 stocks so that the calculations necessary to re-balance do not get tedious. At the end of every quarter after initial investment, the stock holdings are rebalanced so that the investment in each stock is in the same proportion as the initial investment. The stocks may, of course, be held for a period long enough to avoid capital gains tax before the first re-balancing.
An example will clarify:
Let us say stocks A, B C and D make up the index. We decide to invest in these stocks in an equal proportion, that is 25% each. So if you have a 1000 dollars to invest, you would invest $250 in each stock.
At the end of 3 months, let us assume A has appreciated to 300, B has appreciated to 400, C has appreciated to 500, and D has depreciated to 200 so that the total holding is now worth $1400. Rebalancing at this point will mean the value of all of your holding in each stock should be 25% of $1400 (which is $350). Since stock A is worth $300, you would invest $50 in further shares of stock A, redeem 50$ from your holdings in stock B, redeem $150 from stock C, and invest $150 in stock D, so that your holding in each stock would now be $350.
This operation would have the effect of withdrawing money from the stocks which have appreciated more than the index and reinvest it in the stock which has appreciated less than the index. The effect of brokerage has not been considered in this example.
The 3 month period for rebalancing has come from Michel Edelson, from his book, 'Value Averaging'. This whole strategy is a kind of value averaging, except for the fact that instead of taking a fixed value for the appreciation desired, we here bring the divergence of the value of individual stocks to an average, so that we are always invested in each stock in the initial proportion. This has the effect of making you withdraw the appreciation from the stocks which are now overvalued and making you invest into the stocks which have underperformed.
The Carvalho Strategy is based on two basic facts:
1. Index stocks are likely to loose the least in a bear market.
2. Index stocks are on average likely to fluctuate in value by about 50% in a twelve month period.
Based on the above facts, the strategy involves investing in index stocks. Pick an index with at most 50 stocks so that the calculations necessary to re-balance do not get tedious. At the end of every quarter after initial investment, the stock holdings are rebalanced so that the investment in each stock is in the same proportion as the initial investment. The stocks may, of course, be held for a period long enough to avoid capital gains tax before the first re-balancing.
An example will clarify:
Let us say stocks A, B C and D make up the index. We decide to invest in these stocks in an equal proportion, that is 25% each. So if you have a 1000 dollars to invest, you would invest $250 in each stock.
At the end of 3 months, let us assume A has appreciated to 300, B has appreciated to 400, C has appreciated to 500, and D has depreciated to 200 so that the total holding is now worth $1400. Rebalancing at this point will mean the value of all of your holding in each stock should be 25% of $1400 (which is $350). Since stock A is worth $300, you would invest $50 in further shares of stock A, redeem 50$ from your holdings in stock B, redeem $150 from stock C, and invest $150 in stock D, so that your holding in each stock would now be $350.
This operation would have the effect of withdrawing money from the stocks which have appreciated more than the index and reinvest it in the stock which has appreciated less than the index. The effect of brokerage has not been considered in this example.
The 3 month period for rebalancing has come from Michel Edelson, from his book, 'Value Averaging'. This whole strategy is a kind of value averaging, except for the fact that instead of taking a fixed value for the appreciation desired, we here bring the divergence of the value of individual stocks to an average, so that we are always invested in each stock in the initial proportion. This has the effect of making you withdraw the appreciation from the stocks which are now overvalued and making you invest into the stocks which have underperformed.
