Handling success can be one of the hardest things for an investor to do well. When a position is moving rapidly higher, it’s often hard to know how to respond. Great problem to have, but a problem nonetheless.
We’ve got a couple of such positions in the SMI portfolios right now. Our commodities position, despite a steep pullback today, is still up 33% over the past three months and change. I’m showing the chart of DBC, which shows the ascent better than PDBC (whose distributions at the end of 2021 distort its chart).
Our recent purchase of gold has also had quite the run before running into a pullback today:
I imagine more than one SMI member is thinking, "That’s great, but we could have used this yesterday!" Fair enough, but keep reading, because I’m not sure these positions are done running just yet.
Risk management 101
Some members will recall that we were in a similar position a little over a year ago with ARKK in Sector Rotation. Many remember that we rode ARKK a long way down after its February peak, which spurred us to make some risk-management changes within that strategy. But fewer will recall that we wrote The Simplest Way To Reduce Risk two days before ARKK peaked last February. That article focused on the easiest risk management tool a person can use systematically to stay on track: rebalancing.
The idea of annual rebalancing has taken hold due to its simplicity and effectiveness, but there’s no reason you have to limit yourself to once-a-year rebalancing. For example, SMI Private Client typically will rebalance positions whenever they move 20% beyond their target allocation (in either direction). This led to a partial rebalancing of PDBC in those accounts toward the end of last week.
Here’s a simple example to illustrate how to apply this technique. Say you entered the year with a Stock Upgrading portfolio of $100,000 and 10% of that allocated to PDBC. As commodities have gone parabolic this month, you would have seen your commodities position go from $10,000 at the beginning of the year to over $13,500 yesterday. If you were using something like a "20% band" idea for your rebalancing, as it moved above $12,000 you would have sold some and reinvested it into your other Stock Upgrading positions.
Granted, this can be tricky to keep track of with multiple strategies and potentially multiple accounts. (Keeping up with that level of complexity is one reason some members end up investigating SMI Private Client where this sort of thing happens automatically for them.)
But even if you only use this approach when you see something zooming in your portfolio, it can be a helpful tool. In other words, you don’t have to spend every evening updating your portfolio in a spreadsheet for this to work. If you notice one of your holdings is racing higher, take a closer look at its weight within your portfolio and it probably won’t be too hard to figure out some rough rebalancing targets.
Nor do you have to make it precise when you do rebalance. Perhaps, in the example above, you wanted to lock in some gains but still keep PDBC overweight in case oil kept running straight to $200. No problem. Instead of selling $2,000 worth of PDBC to bring it back to its original allocation, sell $1,000 instead and let the rest ride. You’re in charge and if you want to rebalance from 12% to 11% instead of taking it all the way back to the original 10% weight, that’s allowed. There’s not a perfect "right" way to do this, but any risk management is better than none.
A word about trailing stops
Another time-honored approach to risk management is to use a trailing stop order. This has the advantage of not taking money off the table until after the stock/ETF has pulled back from its high. In other words, if oil did run straight to $200, using a trailing stop on PDBC would keep you from selling it early (as you would with the simpler rebalancing approach described earlier).
Again, there’s no right/wrong answer here. I like the idea of limiting downside risk via a "mental" trailing stop better than I do actually setting trailing stop orders, but your mileage may vary on that. In other words, I prefer to have a target selling zone in mind, as opposed to a fixed order in place. My experience is I often get busy, forget to update my trailing stop, and end up stopped out at a level I wouldn’t have sold at if I’d been more on top of things.
The thing I don’t like about trailing stops is most people tend to set them at generic intervals — 10% below the prior high, or other "round number" type settings. I’m convinced that today’s algorithmic trading programs seek these levels out to trigger these orders. So using trailing stops can lead to frustration. They’re also likely to trigger on short-lived pullbacks (like today, potentially). But they can be a useful tool in your toolbox if you use them carefully.
What risk management techniques do you use to manage big winners in your portfolio?
