Staying away from deep bear markets is every bit as important as taking advantage of roaring bull markets. The following portfolio analysis concentrates on the former, but the following logic applies equally to both types of markets.
The first step in portfolio construction is the selection of securities and for this analysis I am using the Baker's Dozen portfolio. Trend following models, such as this one, work better for index securities and not as well for portfolios made up of individual stocks. The thirteen ETFs used for this analysis will be identified later.
Main Menu Assumptions: The assumptions used for the following tranche momentum model are:
- Twelve (12) offset portfolios are used so the "luck-of-review-day" is minimized.
- One (1) trading day period is used for each offset portfolio. This becomes clearer in a later screenshot.
- The look-back periods are 60 trading days with a 50% assigned weight and 100 trading days with a 30% weight. The remaining 20% weight is assigned to volatility where low volatile ETFs are rewarded. This information is used to rank ETFs based on performance.
- Only two ETFs are included in each portfolio offset unless there is a tie.
These are the basic assumptions shown in the following Main Menu box.
Portfolio Tranche Model: As mentioned above when discussing portfolio offsets, twelve are using in this example. For example, based on the most recent data, the highest ranked ETFs are BIV and TLT. Both are currently ranked above SHY, our cutoff ETF, and are therefore eligible for purchase or inclusion in the portfolio. Going back over 12 trading days we end up with recommendations for SHY, VNQ, QQQ, TLT, BIV, and MTUM. For a portfolio worth approximately $50,000, the number of shares are recommended for each of the six ETFs.
The following screenshot includes addition risk reduction indicators, but I will not go into them as they are not germane to the main argument. What the tranche momentum model does do is keep investors away from poor performing asset classes such as emerging markets. Keep in mind, this will change in the future. I'm speaking of current data and the information we now have in hand.
Position Sizing Recommendations: Ranking ETFs or applying absolute and relative momentum principles is how we capture returns while reducing portfolio risk. The above tranche momentum model further diversifies risk. Now we come to the third risk reducer and it is position sizing or how much one should invest in a particular security in order to hold down portfolio risk.
One key setting is to determine the maximum trade position risk. In the following screenshot this is set to 1.2% so the value is limited to 6% of the total portfolio. Under the title, Recommended Holdings, recommendations are made for these particular securities and the size of the portfolio. Based on current holdings, VTI and VNQ create the greatest risk to the Baker's Dozen portfolio.
We have one more risk modifier available and it is the manual position sizing worksheet. This is the fourth and final screenshot.
Manual Risk Reduction Adjustments: The following worksheet is nearly identical to the one above, only in this worksheet we have the option of inserting the number of shares we desire for the portfolio and with each addition or subtraction we observe changes in portfolio risk.
Near the top right-hand corner of the screenshot you see that current cash holdings are $10,000 and with the changes I made, the Total New Cash holdings are close to $17,500. Whereas the Current Portfolio Risk is 5.2%, with the changes the New Portfolio Risk is lowered to just under 4.0%. If this were still too high, further adjustments could bring this risk down to an acceptable level.
One final comment. VNQ added unnecessary risk to the portfolio in the Position Sizing worksheet. By placing a stop-loss order at 7% or $72.13, we bring the "unnecessary" risk in line to an acceptable level. Readers will note under Volatility Stop columns there are recommendations, based on volatility calculations, as to what values to use for Trailing Stop Loss Order percentages and/or specific price recommendations one should set for each holding.
Summary: Ranking securities based on absolute and relative momentum positions provides the first line of defense against major draw-downs. Second in the line is the use of the Tranche Momentum Model where we minimize the "luck-of-review-day" rebalancing. The third defensive line is the Position Sizing Model where we control the risk due to investments in specific securities. The fourth and final defensive position requires judgment from the investor, but visual help is available as one can view how the individual changes impact the overall portfolio until the next review event.
Disclosure: I am/we are long VNQ, TLT, SHY, BIV, TLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.