One of the guidelines for constructing your Magic Formula portfolio, as described in The Little Book that Beats the Market, is that each of your 30 stocks should have equal weighting. So after a sale you can’t just invest all the proceeds; you have to calculate how much you should invest in your next Magic Formula stock so the portfolio will be well-balanced. This re-balancing is one of many little issues easy to gloss over when reading The Book that must be dealt with when actually following this investment strategy. Your portfolio probably started off well-balanced as you invested an approximately equal amount in each stock. It’s impossible to keep the stocks equally balanced because the returns on each could easily be radically different; one stock could go up 100% while another one could go down 80%, for example. It’s normal for the stocks to get out of whack during the year, but the re-balancing comes in when it comes time to sell and re-invest in another MF stock
To compute the amount I should invest in a new Magic Formula stock after selling an existing one, I take the value of the entire portfolio and divide by the number of stocks.
As an example, let’s say you invested a sum of money as directed over the past year and that your account balance – including any cash from dividends – is now $60,000. You have 30 Magic Formula stocks. You are due to sell one Magic Formula stock, which means you should reinvest the proceeds in another, identified on MagicFormulaInvesting.com. Your $60k balance divided by 30 stocks equals $2,000. So after you sell your stock that you’ve owned for one year you will invest $2,000 in another MF Stock regardless of the amount received from this sale. A key concept here is to not be tempted to invest all remaining cash in your account in the one stock. This may sound like a good idea because otherwise you will be leaving some cash on the table, but if you do this habitually your stocks will not be balanced. For example, if the stock you are selling escalated in value it may bring you way more than $2k when sold, so you will be tempted to invest all available cash ($3K for example) in the next stock. But then the next stock may have declined in value and bring you far less than 2 grand. Then it will become impossible to keep the values equally weighted because you won’t have enough cash in your account.
This re-balancing will not be a perfect process, partly because stocks have different dollar amounts, and you have things like fees to figure in. It doesn’t have to be perfect, but you should make an attempt keep it close. So when it’s time to sell a stock, simply take the total value of your portfolio and divide by 30 (or the number of stocks in the portfolio). This is the amount that you should invest in a new purchase.
Update 7/25/2020: Since I wrote this post every major online broker has eliminated fees, so you shouldn’t even have to worry about fees complicating your equation.
Leave a Reply