With all that background on how our trading system was created and evolved, it then becomes a matter of proper allocation to achieve the best results. Before I delve into what I view as an appropriate allocation strategy, it is important to step back and realize that everyone reading this report has a unique situation. All of you have different resources to draw on and have different needs in terms of cash flow, liquidity, and risk levels you are comfortable with. I would suggest you seek out the service of a reputable financial adviser who is fee-based. Those fees will either be to create a one-time financial plan based on your current situation and expectations for the future or they will be part of an ongoing relationship with a financial adviser who regularly monitors your investments and your changing situation to manage a portfolio for you with an appropriate allocation based on your unique situation.
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Assuming that you have allocated some of your resources to cash or to fixed income assets, and to less liquid assets, such as real estate, private equity, etc., I believe the most effective way to allocate the resources you want to commit to this strategy is to be 100% invested in it. By that, I mean any funds not allocated to the value portfolio should be allocated to the market behavioral portfolio.
What percentage of the assets should you allocate to the value portfolio versus the behavioral portfolio? That will change over time. At times, there are rare opportunities to pick up something at a real discount in the value portfolio. When a new recommendation arrives for the value portfolio, consider allocating 5% of your funds to that pick. Since I don’t see having more than 20 positions at one time, that should leave you working capital to act on a new position when it is recommended.
What if you are 100% allocated between the value picks in your portfolio and the behavioral strategy and a new recommendation comes out for the value portfolio? You have to make the choice of ignoring the recommendation, entering the value position on margin, or selling some of the behavioral portfolio to raise funds for the value investment. Only you can make that decision. The same sort of decision comes when you are 100% invested and I recommend an additional option position to hedge our portfolio or to leverage an expected market move. (Note, sometimes it is selling covered calls against long positions and it will actually raise cash but I am referring to other option recommendations).
In terms of allocating between SPY, QQQQ, and DIA, the former two are much larger and more heavily traded than the latter. I would weight them accordingly with perhaps a 40/40/20 split in terms of percent that is allocated to the behavioral model.
What happens when the behavioral model recommends a trade on an ETF we monitor daily, such as IWM, USD, KBE, KRE, or TLT? I suggest you treat those as a value pick with no more than 5% of your allocation going to them, and you can choose to buy on margin or sell some of your behavioral positions in order to raise cash. At the end of the day, you need to make the choice of what you will do or you can turn this over to your financial adviser to allocate appropriately for you.
Since most of you reading this are “do it yourselfers” or investment advisors handling this for clients, you just need to be consistent in your application so you don’t find yourself over allocating on margin when things are going well and then allocating only a portion of the portfolio when a draw down is experienced. Often, the best returns are received just after a draw down occurred. Remember that the system will reflect poor trading conditions by making recommendations to hedge positions, go into cash, or allocate smaller amounts of capital. If you are also doing this, it will likely exacerbate draw downs and you won’t be fully invested just as the system gets everything just right.