We're investigating the possibility of cashing in some of our investments when the gains are dramatic, putting the money in some safer, less volatile place - like a Money Market fund - and waiting for the inevitable market decline when we'll ...

>Buy the stock back.
Right, but what we mean by dramatic depends upon the market we invest in and ...

>And your desired portfolio gain, eh?
Yes. We'd like to get an annual return of, say, 10% so if our investments give us 20%, for example, we stash some of that extra money away in Money Market and if the market drops sufficiently, we buy back in ... with funds we've stashed away.

>And that strategy worked pretty well with a volatile market like the Nasdaq.
Right.

>And now you're going to consider ... what?
Asset allocation, okay? Instead of Money Market, we'll put the excess gains into, say, a Bond Fund. Further, we won't worry about periodic rebalancing in order to maintain some ratio of stocks to bonds. (See Stocks and Bonds.) Instead, we'll let the market decide when to sell stocks and buy bonds and when to sell bonds and ...

>Okay, I got it. Continue. That way we can tell everybuddy that we're very interested in asset allocation and diversification and ... >Please. Continue. Okay. We consider the period Jan 1, 1980 to Dec 31, 2000. The yields for U.S. corporate and municipal bonds were like so: The annualized gain for these bonds was 7.3%, so, because these gains are larger than a Money Market we'll increase our desired stock portfolio gain to 12% per year and ...

Fig. 1

>Greedy!
Pay attention. Remember, this is all fiction. Anyway, we'll sell stock (which will be the S&P 500) when our stock Portfolio is 35% larger than desired (that's the Maximum) and we'll buy stock when it's 10% lower than desired (the Minimum).

The Minimum and Maximum and desired are shown in the upper part of Fig. 2 as well as our stock Portfolio (which obligingly oscillates between the two extremes). >What's that light gray graph I see, in Fig. 2, near the end? That's what'd happen if I just put all of my money into the stocks. The bottom part shows the transfers out of (and into) our stock Portfolio. Note that when our Portfolio tries to get out from between the Minimum and Maximum we sell or buy a bunch of stock to bring it back to the desired graph. Note, too, that the number times we buy or sell to rebalance (if we want to call it that!) is rather small. >But that's because you wait for a huge stock increase and ... Yes, quite true, but this is ... >Fiction ... I know. I see that you beat the S&P 500 with an annualized gain of 13.2% over twenty years ... Actually, it's twenty-one years. >Has the volatility gone down? Yes, the anualized volatility for my Total investments (stock Portfolio + Bond Funds) is 13.3% versus 15.0% for the S&P500.

Fig. 2

Fig. 3

>How about 1987? There was a crash that year and ... Here's a graph of 1987: Fig. 3. Notice that I did quite well, considering. >But you never really invested like that in ' 87. This is fiction, right? Yes, but if I had used this strategy I would have done quite well. >Past performance is no guarantee of future ... Yes, yes, I know. >If you started with $15K in Bonds and $100K in stocks then the bond component of your Total investments started at ... uh ... It started at 13%. But, as the years go by and I transfer funds between stocks and bonds that percentage changes ... >Picture! Picture!

Okay, here's a picture which shows the percentage devoted to Bonds and how the dollars in my Bond investments changed.

Fig. 4

>And you ended with about 20% in bonds, right?
Right, but if I had started with $50K in Bonds, all else being the same, then the situation would look like this (where, although my Total return was reduced to 12.4%, the volatility was also reduced ... from 13.3% to 10.5%):

Fig. 5

>But you were talking about investing in the Nasdaq, since you retired, in June '93, and ...
Okay, here's what would have happened had I switched between the NAZ and this Bond Fund:

Fig. 6

Fig. 7

>But look at your 16.7% volatility! How could you sleep at night? You invest in the Nasdaq, you expect volatility. >And in 1999 ... would you have done as well? No ... but I would have made over 45% ... and slept well. See Fig. 7 >So, how do you choose those percentages, like UP 35% and DOWN 10%? Shouldn't the market determine these numbers? Yes, you're quite right. So we'll choose the Maximum to be 2 Standard Deviations above the desired portfolio and the Minimum to be 2/3 Standard Deviations below. Okay?

For the Nasdaq, the annualized Standard Deviation was 27.5%, from June/93 to April/01. Hence we could choose 2 x 27.5 = 55% above, for the Maximum and 2/3 x 27.5 = 18% below, for the Minimum. That would have given us an even better performance.

>Picture?
Here's a picture:

Fig. 8

>I don't like your 18.7% volatility.
Then don't invest in Hi Tech stocks!
But note that our Bond Fund was eventually about 40% of our total investments ... and the Bond Fund had very little volatility.

Besides, if I had invested in the S&P500 from 1980 (using this strategy), my gains would be higher and my volatility lower. Can you complain about that?
>Sure, why not? I assume you have a spreadsheet for all this?

Yes, in fact here's a spreadsheet which contains a collection of about fifty years worth of S&P 500 monthly gains and selects, at random, ten years worth of gains (120 months, eh?) from this collection (every time I press F9).

I can play with the variables and see what happens. The spreadsheet looks like this:

RIGHT-Click on the picture to download a .ZIPd version

>Can I play?
Sure, why not?

You may (or may not) want to take a peek at: Rebalancing and Sector Rotation.