How To Preserve Capital In Volatile Markets

Includes: C, SHY, TIP, TLT, VNQ, VTI, VWO
by: Lowell Herr


Reducing risk with help from a momentum model.

Limit the luck of rebalancing through a tranche model.

Analyze volatility of individual positions to further reduce portfolio risk.

Preserving capital in volatile markets is not only a current concern, but also it is always on the minds of retired investors. How can one limit draw-downs in erratic markets? The following analysis uses the "Swensen Six" as the example portfolio since these ETFs are equity-oriented, broadly diversified, and include inflation protection securities. For readers not acquainted with the "Swensen Six," check this Seeking Alpha article to familiarize yourself with the makeup of this portfolio.

The following analysis begins with a $100,000 portfolio where shares are held in the iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY), the Vanguard Total Stock Market ETF (NYSEARCA:VTI), the Vanguard REIT Index ETF (NYSEARCA:VNQ) and the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). Reducing portfolio risk is a multi-step process that begins with a basic momentum model where the securities selected for potential investments are ranked using absolute and relative momentum principles.

Tranche Recommendations: The following worksheet is the first step in risk reduction as only the top performing ETFs from the "Swensen Six" are eligible for inclusion in the portfolio. Based on the current rankings, the Vanguard FTSE Developed Markets ETF (NYSEARCA:VEA), the Vanguard FTSE Emerging Markets ETF (NYSEARCA:VWO), and the iShares TIPS Bond ETF (NYSEARCA:TIP) are eliminated from consideration due to poor performance over the past 60 and 100 trading days. If you examine the first three Offset Portfolios, you see only SHY and TLT are recommended. In the following worksheet, I set the number of offsets to twelve (12) with a one (1) day separation between the rankings. This is done to minimize the luck of review day as this portfolio is reviewed every 33 days.

In the following screenshot, you are looking at the rankings over the past 12 trading days. Based on the rankings only two ETFs are selected each day unless there is a tie. The percentage allocated to each ETF is calculated on the number of times it is recommended over the past 12 trading days.

Based on the tranche recommendations, we come up with the following portfolio:

  • SHY - 447 shares
  • VTI - 85 shares
  • VNQ - 489 shares
  • TLT - 136 shares

These recommendations do not take into consideration the fact that one or more of these ETF recommendations might place undue risk on the overall portfolio. This is where we move to the next risk reducing screen.

Position Sizing Recommendations: Position sizing is where we take the recommendations from the tranche momentum model and look at individual ETFs to see if any contribute undue risk to the overall portfolio.

Under Recommended Holdings/Shares, the one reduction is VNQ where the suggestion is to reduce the holdings from 489 shares to 339 shares.

If these recommendations are followed, the Total Suggested Cash increases from $10,000 to $11,593. In addition, and perhaps more important is the reduction in portfolio risk from the current value of 4.5% down to 3.5%. To meet this risk percentage, one needs to set stop loss orders as suggested in the Stop Value column or use Trailing Stop Loss Orders as suggested in the Stop Loss column. One would round those percentages down to the nearest percent.

Conclusion: By using absolute and relative momentum principles with the tranche model, followed by a position sizing analysis, it is possible to not only know what risk is involved with your portfolio, but also how to go about limiting the draw-down.

Disclosure: I am/we are long SHY,TLT,VNQ.

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.