Reader Question

The other day I wrote about changes to the portfolio we've made over the last few months that had the goal of making the portfolio less defensive (selling an inverse index fund and buying two stocks and a narrow ETF). The following questions came into the Seeking Alpha version of the post;

1. How do you track whether these top-down tactical asset allocation decisions are successful over time? Is it easy to separate out the impact of those decisions vs. which particular instruments you choose to implement a top-down strategy?

2. Do you think individual investors should be making tactical asset allocation decisions like this, or would they get sucked into the emotions of the market, resulting in buying high and selling low?

I should preface the post by saying I don't necessarily manage the portfolio in the same manner the questions are framed.

As far as how to "track" whether top down decisions are successful, I think performance of the portfolio versus the market and versus my expectation of both provides pretty quick feedback on decisions. An actively managed portfolio is a series of decisions of which some will be right and some will be wrong. Chances are the portfolio can be successful long term if the decisions made turn out to be correct more often than they are incorrect. Someone who is wrong a lot more often than they are right might need to reassess a few things.

One way to reduce the consequence of being wrong is to make more gradual moves which is what I usually do. In 2007 we started repositioning the portfolio for a defensive posture and kept getting progressively more defensive for seven or eight months--true bear markets start slowly giving plenty of time to get out.

Had 2008 been much different and bottomed out in Q1 or Q2 with a much smaller loss the market would have shown signs of bottoming and that being overly defensive was no longer necessary. This is not a claim of cherry picking a bottom but there are various technical and sentiment indicators that can be helpful here and that I shared in real time as it was happening. Frustratingly for the question there is an element of knowing it when you see it and no two events can be identical but they can be similar. Gradual changes in posturing also minimizes the chance of chasing heat.

Some of the specific decisions can be simplistic and validated or invalidated pretty quickly. Our sale during the summer of Caterpillar (CAT) is a good example. In my opinion, CAT will get crushed in any sort of bear market/recession decline. As mentioned in past posts we sold in the mid $90s and it very quickly went to the mid $60s before staging a fierce recovery. The fast decline validated that the market was indeed worried about something from the top down and the rally then invalidated the concern. We took a little defensive action (selling the CAT when we did) as a starting point. Had things continued to deteriorate we would have done more but the market showed otherwise in the price action. If you conclude that our defensive trade, the sale of CAT, was wrong then we reduced the consequence of being wrong by not going 100% cash at that time.

As to whether individuals should do this I've written many times that I think the extent to which a person is actively involved in managing their portfolio is a function of time available to spend and interest in the pursuit. While there is some portion of the investing public that really is not cut out for this (I realize that is harsh but it is true) I think for many people it can be a function of time and interest. I know from having blogged for a relatively long time now there are plenty of do-it-yourselfers who know far more than many professionals. Someone with average intelligence and the inclination to spend a fair bit of time on the portfolio can absolutely have success regardless of whether they work in the industry or not.