Investment Strategy

A Common Sense, Unemotional Approach to Asset Allocation that Can Help Protect Your Portfolio

Sometime common sense isn't that common...
Gordon Gecko Give advice to Bud Fox

In the movie Wall Street, the iconic character of Gordo Gekko told a young Bud Fox, “Don’t get emotional about stocks.” While the movie is fictional and Gekko was using inside information, there is tremendous value in the advice he gave. Don’t get emotional about stocks.

As the volatility in the markets has increased, many investors are probably feeling rather emotional about their portfolios. Some will probably panic if they didn’t already. Others will be watching the market more closely over the coming days because of the new highs being hit seemingly every day. And still others will lose sleep because they are worried about having too much exposure to equities. None of these activities are healthy for your portfolio or for your health.

There are two main theories about asset allocation—strategic asset allocation and tactical asset allocation. Without getting too deep into the differences between the two types of asset allocation, strategic asset allocation is based on an investor’s age and risk tolerance while tactical asset allocation is based on market conditions.

For example, a basic form of strategic asset allocation says that if you take your age and subtract the number from 100, this will give you the approximate percentage of your portfolio that should be invested in equities. For instance a 35-year old would have 65% of their portfolio invested in stocks and 35% in fixed income (100-35=65). A 70-year old would have 30% invested in stocks and 70% invested in fixed income. Of course, this is a very basic methodology, but you get the idea.

Tactical asset allocation uses more of range for the percentages based on market conditions. For instance the model portfolio may say the equity allocation has a range of 50-60%. If market conditions suggest stocks will outperform over the coming months or years, the allocation would be up at the 60% level. If market conditions are suggesting that stocks will underperform, the allocation would shift down to the 50% level.

There are times when market conditions suggest that a 35-year old having 65% of their portfolio in stocks is too much and at other times, 65% might not be enough. If the market is overbought and optimism is too high—a 65% allocation to stocks is probably too much for this young investor. Conversely, if the market is oversold and the majority of investors are pessimistic, 65% allocated to stocks probably isn’t enough.

So how do you decide when to raise or lower the stock allocation?

I would suggest using a four-step process that uses sentiment and technical analysis. When the market is overbought based on a simple long-term overbought/oversold indicator like the 10-month RSI on the S&P 500. Lower your allocation by 10%.

The second step is the sentiment. You could use the Investors Intelligence report or consumer confidence as an indicator of when to lower your allocation by 10%. If the bull/bear ratio on the Investors Intelligence report goes above 3.0 adjust your allocation down by 10%. Again, like with the 10-month RSI, you aren’t jumping completely out of stocks, you are just lowering your allocation a little. You would also want to bump it up by 10% when the indicator goes below 1.0.

One last adjustment you could make is to drop the stock allocation by 10% when one moving average crosses bearishly below another longer term moving average on the S&P 500. It could be the 13-week moving average crossing below the 52-week moving average, or the 10-month crossing below the 20-month.

Is this asset allocation method perfect? Of course not, no asset allocation method is perfect. Can this asset allocation method help you make adjustments to your portfolio so that you avoid big losses in your portfolio? Yes. And avoiding big losses is just as important as capturing big gains when it comes to building wealth.

These four factors can help you use common sense to make portfolio changes and they give you points to look at so that you aren’t making adjustments based on emotion. Removing emotions from your decision making is critical to investment success.

Investment Strategy