Using Asset Allocation to make money in a Flat Market

green leafed tree near withered grass

I am often asked “How do you use allocation and individual stock volatility to beat the market without using market timing?”

This is a great question!

My technique is to rebalance often rather than once a year. Using a computer I have my personal and newsletter portfolios update daily. When they change by a given percentage, I can reallocate to bring them back to my target. This has me buying stocks when they are low and selling them when they are high.

The easy way to explain it is consider an example in a flat market where you are 50% in equities and 50% in bonds. Assume neither pay interest and we are just looking at fluctuations in capital. Lets start with $100,000 with $50,000 in bonds and $50,000 in the total stock market. Lets say the market starts with VTSMX (at total US Stock Market Index Fund) at $10 goes down to $9 in Q1, goes back to $10 in Q2, continues higher to $11 in Q3 and finishes Q4 back at $10.

How would you make money following my technique?

Well, after splitting your investment 50:50 as shown in Table 1, the market goes down 10%. So now you have a total of $95,000 since only half was in the market.

Next you rebalance your assets to get back to 50:50 as shown in Table 1 for April 1 where you end up with $47,500 in both VTSMX (Equities) and Bonds.

You repeat this rebalancing every time VTSMX moves by $1.00 as shown in Table 1.

How about that! Your portfolio grew $506, or 0.51%, while the market completed a full cycle and ended back where it started!

The skeptics will ask “what happens if the market goes up before it does the down cycle?”

Lets see:

Well, it looks like you make $50 more for an additional 0.05%

You will make even more when you consider that your bonds are earning income. I like Vanguard’s Total Bond index fund for its great diversity but GNMA funds are a close second choice or even a mixture of the two is fine.

It adds up

At times when we are getting less than 2% in money market funds, we should not dismiss this potential to gain extra yield just from market volatility. For a $1,000,000 portfolio, an extra 0.5% translates to $5,000! Compound this over 40 years and this can really add up.

Q2: “Kirk, You have done even better. How do you get your better returns?”

The easy answer is I increase the volatility of my portfolio so there are more and larger opportunities to rebalance.

What I do is try to buy a handful of stocks I like very much for the long term but that are highly cyclical so they have very high volatility. I try to give good price points to add to positions and price points to take profits using a mixture of TA (technical Analysis), FA (fundamental analysis) and “seat of the pants luck” (skill?).”.

For me, it has acted like a cash machine and I hope this continues. With ten or twenty stocks in my portfolio, it always seems there is one that I can trim back or buy to get my asset allocation on target.

Of course, the profit taking and buying back or buying new stocks is the “art” part and this involves some skill and some good luck. Bad luck is part of the equation too and so you have to look at a total portfolio over time and compare it to the benchmarks to see if you are adding value.

You should also notice that I make no claims to call market tops or bottoms as I believe this is impossible to do over and over without making mistakes trying to get back in or out too soon.

Conclusion

People can make electricity from the rise and fall of ocean waves. I got the idea of using the markets natural volatility from this and my example above shows how it works to make money even in a “flat market.” For my example, I used a $1 change for VTSMX as the level to reallocate but a smaller number will allow more frequent reallocations and potentially more profit generation. Feel free to email me if you have further questions about this or my newsletter where I cover it in more detail.

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