Rules-based allocation

Many people who invest on their own pick a mix, such as 60% stocks and 40% bonds, and hold it. A rules-based strategy changes the mix when conditions change, following rules written down in advance.

Why write the rules down#

  • You decide once, calmly. The rule is set before a crash, not in the middle of one.
  • You can test it. A written rule can be replayed on history before you trust it with money.
  • You can see why. At any moment you can tell exactly why the strategy holds what it holds.

Four common kinds of rule#

The four starter patterns in the builder are simple examples of each.

  • Trend following holds growth assets while their price is above a long average and steps aside when it falls below. It aims to miss the worst of long declines. The price is whipsaw: selling after a dip and buying back higher when the trend resumes.
  • Buying dips adds to an asset after a short, sharp fall, betting on a bounce. It works in steady markets and hurts when a fall keeps going.
  • Momentum rotation regularly switches into whatever did best recently. It rides long runs and loses when leadership flips quickly.
  • A fixed mix keeps set proportions and rebalances back to them. It makes no prediction at all; rebalancing simply sells some of what rose and buys some of what fell.

How often to check#

The rebalance schedule decides how often the rules run. Daily rules react fastest but trade more, and every trade costs something. Monthly or quarterly rules trade less and react more slowly. Neither is right in general; test both.

One rule in plain words#

The Trend following pattern reads like this:

  1. If QQQ is above its 200-day moving average, hold SPY and QQQ, sized so each carries a similar amount of risk.
  2. Otherwise, if QQQ's 10-day RSI is below 30, which signals a sharp short-term fall, hold QQQ.
  3. Otherwise, hold gold (GLD) and US Treasury bonds (IEF).

It checks these rules every trading day and trades only when the answer changes. Open it in the builder to see the same rules as a tree.

What rules can't do#

A rule only knows what it was told to look at. It can't foresee news, it will act on false alarms, and it will sometimes trail simply holding. The question is whether you can live with its bad stretches, which is what a backtest helps you judge.