Our mantra at TradeSmith is you’ll have the best chance for success if you invest only in stocks with an upward momentum that aren’t in the SSI Red Zone. That is far and away the safest strategy to stay out of trouble for the majority of investors.
But we realize that for many investors, there are valid reasons to hold stocks in the SSI Red Zone. You might have low cost-basis stocks on which you don’t want to pay capital gains. You might have a high conviction idea that you don’t want to use a stop-loss strategy for. You might participate in an employee stock purchase plan.
There are two things that should be considered when owning stocks in the Red Zone.
The first is that even if you have stocks in the Red Zone, you want to be sure that your portfolio remains “right-sized.” This means looking at your portfolio on an annual basis and being sure that you’re taking an equal risk per position so that you have more money invested in your more conservative stocks and just the right amount of money in the riskier stocks that can blow up your portfolio.
This simple but profound position-sizing strategy more than doubled the average performance of over 40 individual investors over a 16-year period. The blue line in the chart below shows the impact of this strategy on improving the performance of this group versus the black line, which is their original collective performance.
Having an intelligent approach to position sizing is serious stuff that should never be overlooked or underestimated.
While smart position sizing is something we’ve talked about many times before, our second suggestion for what to do when you hold stocks in the Red Zone is a new one.
This year we’ve written multiple times about a sector-based strategy for beating the S&P 500 using the 9 ETFs of the Select Sector SPDR ETFs from State Street.
One of the most interesting parts of that research for us was the question of when to go completely to cash. In the original study, we used a rule that if 3 or more of the 9 sector ETFs were in the Red Zone, we discontinued adding any new positions and sat on the cash. Only after 7 of the ETFs were back in the Green zone or Yellow zone were new purchases made. That was a very powerful rule.
We recently expanded on that research and asked the question, “How much of a portfolio’s capital can be safely invested in stocks that are in the Red Zone?”
The answer that we came up with is 40%.
Now before we go any further, we implore you to please be careful with this idea. This is not an endorsement of putting up to 40% of your portfolio into stocks in the Red Zone. We still feel strongly that the majority of our portfolios should be in stocks that are in the Yellow Zone or the Green Zone.
What we will say today is that if you are going to be invested in stocks that have a red SSI, then make sure that no more than 40% of your portfolio’s dollar value is invested in these stocks.
Why do we say this?
The below chart takes a little time to understand but it tells the story.
What it shows is a system that is in the market when 60% or more of the portfolio’s capital is not stopped out and is out of the market when 40% or more of the portfolio is stopped out.
The bottom area of the chart shows the percentage of the portfolio not stopped out. The red line is the critical threshold at 60%. As long as more than 60% of the portfolios assets are in the Green Zone or Yellow Zone, it’s smooth sailing. When 40% or more of the portfolio’s assets are in the Red Zone, it’s time to step aside from some or all of these positions by either going to cash or investing in other stocks that are in the Green Zone.
So, if you’re going to hold on to some of your Red Zone stocks, you’re taking more risk, but it can work. Just make sure that:
- You’re still using smart position sizing; and
- You never have more than 40% of your portfolio in assets that are in the SSI Red Zone.
TradeSmith Research Team