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A new book in the Market Wizards series (by author Jack Schwager) has come out this month. While these books are a collection of interviews of great money managers -- Schwager himself also does a nice job of summarizing some of the themes he personally has gleaned by incorporating his decades of experience into a series of observations.

He also recently summarized a few of these observations on his twitter account (@jackschwager).

A few of his takeaways from interviewing top money managers:

  • It is not about predicting what will happen -- but rather recognizing what is happening
  • Many go wrong by failing to adjust exposures to changing market volatility

This all conveniently ties into using Relative Strength to help recognize what is happening. This is foremost. But on the second point, we let's think about how to adjust exposures to changing Market Volatility and take a look at one example.

Think about the Russell 2000 Index (NYSEARCA:IWM), which is the most popular index for small cap U.S. stocks and which is one of many important market segments we can access at ultra low-cost (and never pay any redemption fees or lock-ups with ETFs) and it of course has total transparency and is deeply liquid.

Think back to 2010 for one interesting example of how this segment has traded.

2010 was a very good year -- but you wouldn't have said that during the summer of 2010 when the index was showing a loss after a large drawdown following a flash crash in May and yes, continual negative news flow from ... drumroll ... Europe. The final IWM return was very strong +27% but masks the mid-year washout and pain many investors felt.

Here is 2010 as full year snapshot.


(Click to enlarge)

Go forward one year to 2011, the IWM final return of -4% for IWM also greatly masks the 'path-taken.' Another large drawdown, this time -29% and about the same actually as the European index loss (VGK was off -30% from peak to trough).

This is very important and something that investors must study a great deal -- the long-term return of the markets is not all that great in relation to the often wild path taken to get that return. That is, a long-term return of say +7% might have huge drawdowns along the way that cause investors to actually end up losing money if they don't learn how to deal with this.

(In modern portfolio theory terms, you describe this situation (low return relative to high volatility) by saying simply that the Sharpe Ratio is not very good.)

If the short-term S&P 500 sharpe ratio gets really high, just wait -- it's coming back in at some point. This is what happened in Q1 2012 when the annualized S&P 500 YTD sharpe ratio was over 3.00 at one point. We noted this as an unsustainable figure on our Allocations board timeline.

And now we see the very normal washouts that occur with volatile assets. If you want a more efficient equity curve, then don't buy and hold volatile stocks -- unless its part of a well thought-out allocation that adjusts to prevailing conditions.

On the Tools page is a new module "Volatility Target Test." This module executes a convenient, clean performance backtesting report for you complete with detailed period-by-period weightings and return.

It combines any ETF of your choosing (such as IWM) with a cash-like ETF (NYSEARCA:SHY) and allows you to therefore approximate a level of volatility for the combination based on changing (dynamic) market conditions. It continually adapts to the current environment and records the performance of such a mechanical targeting approach.

It should be clear that if you target low volatility and the market goes up a lot -- then obviously a risk-aware strategy will underperform in the short-run. But if you target lower volatility and the market goes down a lot, it will then outperform. The point of the application is not to be an optimal weighting, it is to help understand how volatility targeting works in different environments and across different market segments -- and in turn, it helps show a way in how to avoid one of Schwagers main points repeated here:

* Many go wrong by failing to adjust exposures to changing market volatility

Below is a single view screenshot of the new ETFreplay volatility Tool:


(Click to enlarge)

Source: Market Wizards Adjust To Changing Conditions