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Using Disciplined Stock Market Timing For Portfolio Rebalancing

Updated on March 4, 2012

My Experience With Stock Market Timing

Over the years I have given a lot of thought to market timing strategies. I first wrote about it in July 2007 when I demonstrated that the stock market was overvalued and warranted a reduction in equity exposure. Since then I have achieved pretty good results with market timing, which have ever so slightly cushioned some of the blow from the market declines of the last few years.

In subsequently thinking about this topic and discussing it with friends I have come to realize that what I refer to as market timing or hedging can just as easily be thought of as frequent portfolio rebalancing. I wanted to see how the results of rebalancing compared to what I’ve been doing for the last 11 years so I decided to test it. I ran analyses of two different portfolio rebalancing strategies under a scenario where the market declines steadily over the course of 14 periods, where a period is defined in terms of a 5% drop in market value from the previous level - much like my buy and sell thresholds. At the end of 14 periods the market is at approximately 50% of its original level - not too different from where we were at the depths of the bear market. Under each strategy I started with a portfolio that was 70% equity and 30% cash - a hypothetical $1MM total to make it easy - and rebalanced the portfolio at the end of each period.

The first strategy is based upon maintaining a constant 70% equity exposure and is demonstrated in the table below.

As you can see, over the course of time each subsequent stock purchase becomes smaller as the portfolio shrinks and smaller purchases are sufficient to offset the market declines. At the end of the 14 periods the total portfolio is down to a bit less than 61% of its former self and the cash position is down to $182K from $300K originally. Of course, I would argue that with the market at a lower level the portfolio is well positioned to benefit from any recovery, which is the basis of my market timing strategy.

The second strategy is much closer to the approach that I have been taking and is based upon maintaining constant dollar stock purchases - initially matching the stock purchases in the first strategy - and is demonstrated in this second table.

The Conclusion About Stock Market Timing

Surprisingly, at the end, the total portfolio value isn’t that much different than under the first strategy but cash is about $30K less. The main difference with this strategy is that at the end the portfolio is almost 75% equities, up from an initial 70%. This seems reasonable, and might even be too conservative. If one believes that 70% is an appropriate equity allocation at one level of the market wouldn’t a higher allocation be reasonable when the market is 50% cheaper?

I draw a couple of conclusions from this exercise. First, when faced with a rapidly changing market, I believe it makes sense to frequently rebalance the portfolio to take advantage of higher or lower valuations. Why should you wait until the end of the year when things might be a wash? Second, given the numbers from the second strategy, I think I have been too conservative in the magnitude of my incremental investments as prices have gone down. Of course, I’m waiting for the market to drop another 50% to really pick up the bargains.

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