Every day brings new evidence of market exuberance. I mentioned a few of these examples in the February SMI newsletter editorial, The Wisdom to Show Restraint, but those are just the tip of the iceberg.
There are countless others we could point to: the incredible proliferation of "SPACs" (this generation’s version of the IPO craze from the late-1990s), the huge volume of trading in the market’s most speculative "penny" and "over-the-counter" stocks (those too small to be listed on the major stock exchanges), and so on.
One closer to home example of the market’s exuberance is the stunning recent performance of SMI’s Sector Rotation strategy. After rocketing +23.77% in November and another +12.61% in December, SR is already up an additional +24.45% so far in 2021! (All performance is through last night’s close, 2/9.) This most aggressive SMI strategy is now up +96% since August 1, and perhaps more scarily, +73.5% since November 1, barely over three months ago.
While it’s great fun watching gains like those accumulate in our portfolios, what about the admonitions at the end of February’s Restraint editorial that cautioned about not taking more risk than is required to meet your goals? When the first five weeks of the new year hand you the level of gains you might normally expect to be stretched over a year or two, it’s worth thinking about the risk side of the picture.
The good news — this doesn’t have to be difficult: The easiest way to reduce risk is simply to sell a little of your winners.
Why it makes sense for some
I know, I know — SMI often preaches about the virtues of letting our winners run. One of the secrets of momentum investing is that we’re not constantly guessing about what will happen next and cutting our winners short by selling them too soon.
So to be clear, what follows isn’t across the board instruction for everyone. Instead, it’s specifically for those who want to de-risk their portfolio a bit and are looking for the simplest way to accomplish that. Others may be comfortable leaving things alone and letting their winners ride. If nothing else, this information will be available if they reconsider after SR runs another 20% higher!
Let’s look at a simple 50/40/10 portfolio as an example. For simplicity, I’m going to assume the entire Upgrading allocation is in Stock Upgrading (no bonds). This same process could easily be applied with Bond Upgrading simply listed as a fourth portfolio component.
If someone had started the year with $100,000 divided 50/40/10, their portfolio would look like this as of last night:
Dynamic Asset Allocation (50%) | +1.6% | $50,800 |
Stock Upgrading (40%) | +12.1% | $44,840 |
Sector Rotation (10%) | +24.5% | $12,445 |
The great news is their portfolio has grown from $100,000 to $108,085. That’s an overall gain of +8.1%, significantly better than the +5.7% gain of the Wilshire 5000 index or the +4.4% gain of the S&P 500 index.
While the portfolio isn’t wildly out of balance at this point, the original allocations have shifted to 47% DAA, 41.5% Upgrading, and 11.5% SR.
The simple solution to de-risk this portfolio a bit? Sell the extra 1.5% of Sector Rotation and divide it between the three DAA components.
This won’t perfectly rebalance the portfolio, as Upgrading will still be slightly overweight and DAA will be slightly underweight. After taking this simple step, the portfolio will be 48.5% DAA, 41.5% Upgrading, 10% SR.
Importantly though, a full rebalance of the portfolio wasn’t our goal here. We simply wanted an easy way to tap the risk level down a bit without resorting to anything drastic like changing the portfolio allocations. This person started the year with the goal of having 10% of their money in Sector Rotation and that’s exactly what they’ll have after making this quick adjustment. (Of course, they could take this further by selling some of their Upgrading winners as well, but it’s not necessary.)
Pruning and replanting
"Periodic rebalancing" is the fancy term for this, and it’s something our affiliated partners at SMI Advisory Services do automatically for the Private Client portfolios managed there. Whenever a particular portfolio component gets too far away from the desired allocation within a Private Client portfolio, the position gets pruned and that money replanted somewhere else.
This can obviously get a little complicated when a person has multiple accounts and several strategies involved, which is why there is software to handle it at the professional level. But as we just saw in our example, it doesn’t have to be particularly complicated, especially in a situation like this where there is really only one strategy position that needs to be adjusted.
Again, just to be clear, this discussion shouldn’t be taken as instruction for everyone to run out and rebalance their portfolio. Some members may prefer to leave SR alone and hope for further gains by letting their winners run. But for those looking at the current market and their own portfolio and wishing there was an easy way to tap the risk level lower without making any drastic changes, this is a simple way to accomplish that.
