One thing that I do differently than most investors is the concept of rebalancing.? I buy and sell positions to maintain their weights in the portfolio, within a 20% band around the intended weight.? As I wrote about it at RealMoney:

The two smaller purchases were done for a different reason than the other trades. I already owned Petrobras (PBR:NYSE) and Dycom (DY:NYSE) , but both had been performing badly. Their weight had shrunk to be the smallest in my portfolio. After a review of their fundamentals, I did what I call a rebalancing trade.

When I interviewed fund managers, I would often ask how they would rebalance positions in response to market movements. Many of them would do nothing; others had no fixed strategy. However, three of them had really worked on refining their strategies, and to my surprise, their outcomes were similar — even though other aspects of their styles were different. One was value, one was growth, one was core, but they each had evidence that their approach improved their returns by a few percent per year. That caught my attention.

One cost of trading comes from whether a trade demands or supplies liquidity to the market. When a trader posts a limit order, he or she offers other market participants an option to exchange shares for liquidity at a known price. In offering liquidity, the trader hopes to get an execution at a favorable price.

The approach that the three managers use — and that I employ in my personal account — is as follows:

• Define a series of fixed weights for the stocks in the portfolio.
• Do a rebalancing trade when any position gets more than 20% away from its target weight. The 20% figure is arbitrary, but I think it strikes a balance between excessive trading and capturing reasonable trading profits by providing shares and liquidity to the market when it wants them.
• Use this time as an opportunity to re-evaluate the thesis on the stock. If the thesis is no longer valid, exit the position and buy something that you like better.
• If the rebalancing trade generates cash, invest the cash in the stocks that are the most below their target weights, to bring them up to target weight.
• If the rebalancing trade requires cash, generate the cash from selling stocks that are the most above their target weights, to bring them down to target weight.

This discipline forces you to buy low and sell high and to re-evaluate your holdings after significant relative market movement. This method works best with companies that possess low total leverage relative to others in their industries. This helps avoid the problem of averaging down to a huge loss.

It also works best for diversified portfolios with 20 to 50 stocks, with reasonably even weights. In my portfolio, the weights range from 3% to 7%, with 33 companies altogether.

The incremental profits add up as companies and industries fall in and out of favor, and the rebalancing system buys low and sells high.

Now, one aspect of this that I did not write about at RealMoney is that it saves on taxes.? In a very volatile market, like we have had over the last three years, and that we had 2000-2004, there were a lot of opportunities to buy low.? Now for someone like me, who runs with 30+ positions, a sharp move down and up feels like this:

• At the start of the move down, I have realized and unrealized capital gains.
• As the move down proceeds, I have realized gains but no unrealized capital gains.? I have redeployed? money into defensive industries, or, at least stocks that are undervalued.
• Further into the move down, I have no realized gains and and I have unrealized capital losses.? I am still redeploying money into defensive and cheap investments.
• Still further into the move down, I have realized losses and and I have large unrealized capital losses.? At this point I should be moving into economically sensitive names, and add cyclicality.
• I may have to do that twice, or even three times, but eventually a bottom comes.
• As the move up begins, I have realized losses and unrealized capital losses.? As I sell stocks to reinvest in better companies, I sell stable names to buy cyclical ones.? As stocks hit my upper rebalancing points, I sell high tax cost lots, and hold onto the low tax cost lots.? My realized losses grow.
• As the move up continues, I have realized losses and no unrealized capital losses.? I continue to sell high tax cost lots of companies that have hit my rebalancing points.
• Further into the move up, I have no realized losses, and unrealized capital gains.? My rebalancing and other sales are now creating small gains.
• Still further into the move up, I have realized gains and large unrealized capital gains.? I then look for my largest unrealized long-term capital gains in stocks that I would like to sell, and donate them to charity.? Fidelity Investments makes that very easy.? After the year end, I repeat that process.? The advantage is that I don’t get taxed on the capital gain, and I get a full tax deduction on the market value of stock donated.

I do almost all of my charitable giving via appreciated stock.? It works well.? Given the volatility of the markets, for those that have a diversified portfolio, and a dedicated reason to give to charity, it is a free lunch.? I marvel each? year at the ways that I eliminate capital gains, while still managing to make good money in stocks over the long haul.