Hi Bill,
1. Yes, the 40% drawdown was because, at that time, I didn't have a lot of cash in the account to cushion it. For my account, I set the maximum amount of cash to be 30% (after that, I use the excess cash to buy more positions). I think I had 10% cash at that time.
Actually, the drop let me test the "doomsday scenario" - I had to add cash from other sources and I didn't have enough to rebalance all the positions, so I had to use the "triage" rule and sell some stocks at a loss to build cash to rebalance other positions.
It paid off with the +44% return the next year - though I made a mistake there. I was nervous with the gains and so I rebalanced in the middle of the year. If I had stuck to my system and rebalanced at the end of the year, I probably would have made more than 44%.
2. Now, I'm keeping more cash in the account to dampen the swings. I'm keeping the cash in a no-load short term bond called AALPX. I also added a couple of REIT stocks.
3. I think non-correlated assets will reduce volatility. Though, in 2008, everything dropped. As far as total returns, I'm not sure if you will still outperform the market, but you should at least match it with less drawdown.
