Mechanical Portfolio Management 101

Mechanical portfolio management can make your investing work easier.  In upward or downward markets knowing when to take a profit or when to buy can be difficult.  Using a simple mechanical portfolio management allocation balancing method can mitigate challenging market decisions.  This is a rule based tactic which can help to keep you on track.

mechanical portfolio management

A portfolio allocation is your balance of investment types that will fit the current economic outlook or direction.  For this mechanical portfolio management example we’ll use a strategy of stocks and short term cash.  It can be indexes, stocks, or whatever works for you.  Once you decide on products, then you compile your allocations and percentage balances for your portfolio.  

Using an example of stocks and short term money market funds let’s say our sample portfolio consists of eighty percent stocks and twenty percent money market funds or an 80/20 allocation.  Once this is set up and invested our next step is to use a mechanical portfolio management technique of re-balancing the portfolio when it gets too far out of balance.  In this example we will re-balance with as little as an eight to ten point difference to show how it works.  

I calculate the eight to ten point difference by adding the amount that both sides have changed together from the original ratio.  So if you start with an 80/20 ratio and it’s now 84/16 that’s a four point change on each side (80+4 and 20-4) equaling an eight point change.  The key here is you want to use this to lower your exposure to markets that move greatly in either direction.

Mechanical adjusting of the portfolio once a year is good if out of balance, or upon a major economic change, or market move, but if it isn’t a substantial change in your portfolio then don’t tinker.  The major tactic of this strategy is to force you to take some profits or move money out of non-performing positions occasionally, and to have cash around to take advantage of great opportunities when the markets are irrational.

Mechanical Portfolio Management at Work

To give you an example of how this mechanical portfolio management works let’s say the market has risen, and using the 80/20 portfolio we mentioned above, and starting with an initial investment balance of $1,000 equaling 80% stocks and 20% cash for this example.  Let’s say the portfolio rises to $1,500.  In our example, the stocks now comprise $1,290 of the portfolio, and the money funds comprise $210 of the portfolio.  Your starting balance of 80/20 has now changed to 86/14.  

At this point you would rebalance the portfolio back to 80/20 by selling some of your stocks and adding to your money funds.  This would require selling approximately $90 of stock.  It would look something like this table below:


This also acts as a defensive strategy reducing your exposure to equity downside risk.  When we have multiple years of macro expansion as we did from 1995-2000 and 2009 till 2019 with micro sell offs in between it sets your portfolio up to capitalize on sell off opportunities.  I use this tactic to take advantage of fear or jubilance in the markets.  It’s a good way to keep yourself in check by sticking to a rules based method that will help mitigate your ego and emotions.   

In Daniel Crosby’s book The Behavioral Investor, he states that over history on average, bull markets last 8.9 years and bear markets 1.3 years with the average cumulative loss in a bear market of 41% as occurred from a macro perspective between 2000 to 2002 and 2007 to 2009.  Working through these types of markets can be emotionally challenging to deal with and hard to know what to do, so most people sit on the sidelines and wait while their stomach turns.  Having a rule based strategy will keep you on top of what to do when the rules are triggered.

There can be some drawbacks to using a mechanical portfolio management strategy, such as if your stocks are not in a retirement account then you could incur tax implications when selling positions, or selling your winning stocks might be against your ideals.  If you buy and  a down market continues after you’ve adjusted your portfolio it will exacerbate the percentage of portfolio losses on paper, but as a counter your average ownership cost will be lower, so when things do return you’ll reach profitability sooner.  

I advocate long term thinking or investment strategies in all situations.  As Warren Buffett says, “if you’re not going to be in it for ten years you shouldn’t be in it for ten minutes.”  This tactic works with long term investing best, so trimming a winner some won’t bother much, or if you’re of the mindset to let your winners run it forces you to cut your losers.  If the market continues downward after you made an adjustment it just means you’ll maybe get to make another adjustment at a lower price and become an opportunity rather than fear. 

ten years of mechanical portfolio management

The most important component to a mechanical portfolio management strategy is it has to be used with a counter component that is liquid such as cash and not at risk.  This tactic is meant to force you to take advantage of potential opportunities in a more mechanical way without having to think about it.  Adjusting your allocation percentages based on the economic outlook can also add to this tactic.

For more ideas check out my Over 50 Smart Posts.