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  • Mike Komara

Rules-Based Approach to Investing

Updated: May 16

Rules-Based Investing

“Victorious warriors win first and then go to war, while defeated warriors go to war first and then seek to win.” – Sun Tzu


The world is changing. But isn’t it always? It’s always amazing to us how many in the investment world do not subscribe to a rules-based process that presupposes change. To us, this means employing a process based on time-tested principles without the use of predictions or emotion. We are far more interested in a repeatable process than being right on any random market call.


A little market volatility always seems to bring out the financial “experts” with their eulogies for the market. These predictions are just noise. But, it’s completely within the realm of human nature to fear an impending crisis when volatility increases, especially when coupled with negative economic/geopolitical headlines. The environment of the last 10-years has not helped with volatility, on average, running at historic lows.


In this blog, we discuss how knowing how you will react to changing market conditions helps reduce emotional reactions spurred on by fear, especially now as volatility increases and markets decline. The idea is to protect against the “compound killers” and accept the noise in return. Since nobody has a crystal ball, the optimal approach in our view is to apply a predetermined, disciplined, rules-based approach to asset allocation.


When the Check Comes

Treasury Secretary Janet Yellen told Congress that the Treasury would be unable to pay all the government’s bills if lawmakers don’t raise or suspend the federal borrowing limit by Oct. 18. The letter from Yellen makes clear that lawmakers have a narrow window in which to approve a debt limit increase or suspension before the Treasury could begin to miss payments on its obligations, triggering a default that could shake markets.


S&P 500

Because it’s been a while since the S&P 500 declined by 5% (March 2021) or greater (November 2020), investors could perhaps be forgiven for forgetting what volatility feels like. Forgiveness notwithstanding, September in general and more specifically the Evergrande meltdown brought a reminder of how fast sentiment can change. After two positive days to open the month, the S&P 500 Index experienced 10 losing days out of the next 12, falling 5.4%.

Interestingly, the effects of volatility seem almost more a product of the environment they directly follow than of volatility itself. In other words, it is not volatility that scares people but the rate of change in volatility. For example, this same level of volatility in April 2020 after the Coronacrash would have drawn less response as investors acclimated to the new regime. However, newly developed volatility following six months of steadily increasing prices produces a visceral response.


While the timing of the volatility spike might have been unpredictable, the general public’s reaction to it was not. For the first time since the Coronacrash, we have been hearing fretting among investors about their accounts. Should they reduce exposure to international markets or increase cash? Is "So & So" the next Lehman Brothers? These are the types of questions we have been hearing.


Buy Rules: Enter a Position Correctly

As crucial as identifying the best time to purchase are those when it comes to rules based investing. Some investors question the timing of an investment and how much it costs to buy and sell it. We have nothing to worry about. It is a successful strategy to gain more profits than the average while avoiding losses from the major downturns. Timing is a key difference in buying and selling a property and can provide many advantages. Market timing may not be a common consensus for many people, but there may be a consensus in the buying process and its emotional reaction is especially evident. Generally rules based dictates time for purchase, but it's more about feeling versus emotion.

Asset Allocation Rules: Balance Risk, Keep Your Holdings Manageable

Even if you select the top stock, if no plans exist about where you can put your investment portfolio in your portfolio before you purchase, your portfolio could cost much. These are all components of rule based investing. Instead of making investment decisions at market time, a sound stock portfolio strategy should be created before Tuesday's opening.


Keeping a balanced system through rule based investing helps clarify your decision-making and gives you additional defense against possible mistakes. A company's portfolio management rules set the amount of equity that is appropriate to invest in a given period. So the stock can be bought without feeling over-emotional based upon individual sentiments.

Stock Selection Rules: Find the Right Ideas for You

To determine which securities will be suitable, investors will need to establish an investment method which matches their investment criteria. They can then find their own interesting idea using a robust stock screening tool. Whatever investment strategy, screening stocks is a necessity with a resource based on institutional-quality records. It's crucial to understand fundamental data, especially the earnings and revenue growth. The shop focuses on growth-focused entrepreneurs. We then select any company which is not increasing profits more than 25 percent each quarter.

Sell Rules: Lock in Wins, Avoid Losses

Ideally an investor should use two sets of sales rule: one for locking into profits and one for protecting against excessive losses. As a position shows a significant gain or loss, it is likely emotions are influencing your decisions. This is why selling rules is vital. This will help you to overcome these painful emotions and focus your actions accordingly. Similar to a doctor consulting chart or radiography to see how to correct the condition. We have a rule that keeps capital in place in order to prevent recurrence of losses by 5%.

Autopilots and Algorithms in Rule Based Investment Strategies

Does checking lists help with decisions for investors? Using hand movements, the resulting bumps create synchronized speeds to avoid accidental mistakes. Another tool provides even greater rigors. Dollar costs are estimated based on a standardized schedule. During your planning period, you will determine what you want. Did we really win? Invest in the best way possible. Is that not a good idea? This invites the most investors into ruin without a proper investment strategy. What about them? Is automatic piloting a necessity? Fund managers use these tools to encourage buyers when they may otherwise not be willing. While institutional investors on the other hand, are calculating risk factors & investment objectives manually to please clients.


Tempering the Uncertainty in International Stocks with Process

We often talk about the importance of process. September’s action is another great example of this. From a process perspective, our attention to market prices (rather than predictions) meant we were proactively shifting our portfolios away from emerging markets ahead of the media frenzy around the Evergrande news. At the end of July, our portfolios reduced exposure to emerging markets by as much as 40%. In terms of communication, always having a plan via disciplined processes allows us to communicate what is happening and what you can expect.


Closing Thoughts

Looking ahead, should international trends continue deteriorating, we will methodically reallocate toward stronger U.S. equity segments should conditions remain stable across asset classes. This regimented handoff process will not only reduce risk but also take advantage of opportunities through our single stock process in eligible accounts or via our mutual funds, index funds, or rules based funds. Lately, reducing risk and taking opportunities has meant shifting exposure from sectors like Industrials and Materials to toward Technology and Healthcare. Rules-based investing has been a key player in making this happen.


In fixed income, we will continue retreating from weaker segments of the yield curve or weaker geographic regions, while moving toward areas that are doing a better job of protecting capital. Said another way, we will continue to set aside our egos and listen to what the stock market data is telling us. Whether it is a stock market insider, member of the Fed, or member of Congress, someone always seems to know, and price usually reflects that knowledge.


In closing, we want you to feel confident in the plans you have made and are currently making. When you want sound, measured investment advice and expert insights into your asset allocation, contact Solas Wealth.





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