May I ask what precisely is your metric for when to reduce your allocation, and what metric for how much to reduce it to?
As best I understand, there are three factors:
1. Volatility. What is the current S&P 500 volatility? This can be measured using historical numbers or forward-looking numbers. Either way, it tells you how much the market is moving up and down. Sometimes it's 0.5% per day on average, sometimes it's 3% per day on average. Usually, bigger moves happen to the downside.
2. Recession Risk. Bond spreads (most popular is 10-year to 2-year Treasury) predict recessions and healthy market periods. Flattening yield curves raise recession risk. The spreads are turned into a predictive indicator by seeing exactly how they affected the market in the past (I linked above to a guy who wrote articles about this and has been very successful with using the approach. He's definitely smarter than most, but also clearly not the only one doing this.)
3. How much am I willing to lose? In my case, it's 50% of my portfolio.
So what you do is simulate all stock market history since the early '70s to see if, given CURRENT volatility and recession risk, you could have EVER lost more than 50% of your money by investing X% in the S&P 500. Ultimately, the answer is that I absolutely cannot lose 50% of my money right now by being 100% invested, so it's optimal for me to stay all-in. According to my colleague, this is a very common way to gauge investment risk and to optimize portfolios, especially among sophisticated fund managers who use "volatility targeting" approaches. You want to limit exposure to volatile things, because volatility means you can, CONCEIVABLY, lose more money than you're willing to lose, which is unacceptable. That exact limit where you could lose more than your risk tolerance is where your "correct" allocation is.
I don't know if this is exactly a Monte Carlo simulation, but it's at least a very similar approach. I don't know how to get a screengrab of the PDF document on here (and that is probably against the terms of service anyway), but suffice it to say that over the past 10 years, the S&P 500 is up 150% and the 50% risk portfolio is up 148.9%. But the limited risk portfolio only had a FRACTION of the losses in '09.
On a longer timeframe, you can really start to see why avoiding the worst of recessions ends up being better for compounding. Posted this performance link above already, but here it is again:
https://safer401k.com/how-it-works/performance-since-2000/Thanks to more aggressive allocation, the 50% Risk Profile returned 134.98% — quite a bit more than the S&P 500’s 97.5%.
Is this cherry-picking a pretty lousy period in the market? Maybe, sort of? I don't know. But fear of getting in at the "wrong time" has always gotten to me. And it never helped that people tell me that no time is the wrong time... because that's absolutely not true if you're hoping for gains from 2000 to 2013.
I find this whole thing convincing not least of all because my IT/programmer colleague is much more informed than I am about trading and portfolio management (and gambling) and he uses this method exclusively for his TSP account. It's literally the best of all worlds -- keep me in the market all the time but step off the pedal when potential losses are higher than I can stomach (a number I provide).
Sorry if it seems like I'm proselytizing. I just think that some of the more rigid buy-and-hold dogmas fly in the face of logic.
P.S. If we're going to keep on bringing up Buffett, here's my pick:
Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.