Accepting that the market is efficient most of the time does two things to your trading psychology. It forces you away from even caring about a single trade to one of simply caring about the next few thousand trades and ensures for your long term survival that you must seriously reduce your return expectations, leverage appetite and focus on risk management.
In any complex system we inevitably come across the predominance of some patterns or relationships over others. For example we talk a lot in trading circles about the ‘fractal’ nature of markets or the dominance of certain features such as the Golden ratio or Fibonacci sequence. Now is this just BS for the tea leaf readers or is there something deeper in the significance in certain features of the data?
Part 3 which is the final installment of this series focuses on fine tuning the portfolio and adding realism to the backtest results. Before we can pluck the courage up to launch into our live trading following our exciting back-test results, now comes the time to remove any bullish euphoria and focus on the reality of live trading. We do this to dampen our expectations and ensure our risk weightings are correctly applied for live conditions. This is where the brutal reality of the frictional costs of trading need to take center stage….as we inevitably incur additional costs to that anticipated from our back-tests attributed to the realities of live trading.
In Part 1 of our 3 Part article titled “Creating a Powerful Blend from Scratch”, we commenced the portfolio optimization process by selecting our primary system upon which we would then apply diversification principles across instruments and asset classes to achieve a bigger bang for buck in terms of risk-weighted returns for our finite investment capital. Part 2 of this installment article focuses on how we go about this blending exercise.
In my previous article which introduced you to the world of practical portfolio management, we summarized the key criteria you need to consider when creating a portfolio from scratch. This article was theoretical in nature…..but now it is time to put the theory into practice and take you on an exciting practical journey where we apply these sound principles to create a robust portfolio performer offering sustainable risk-weighted returns.
October 2018 has tested the resolve of trend followers where we have suffered a similar fate to February 2018 and have witnessed a fairly nasty whipsaw in Energy, Fixed Income and Equity markets. Given that we had just caught the waves of September’s volatility surge….all our hopes for the emergence of some good enduring swells in our direction were shattered as mean reversion started to enter the mix as markets rebounded sharply from their maximum adverse excursions resulting in some crazy double-up formations and some spectacular wipe-outs.
What portfolio management is all about is to engage in a systematic method of constructing a portfolio of investments from ground up that utilises principles of risk management at all steps along the way to achieve an optimal risk-return profile.
September 2018 saw the re-emergence of volatility in the equity markets with an ensuing decline in the S&P 500 TR Index (includes dividends) of 6.83% for the month. Does this small blip in an otherwise linear ascent in the Index since January 2009 signal further volatility ahead….or like February 2018, will we see a return to the progressive surge of the Index to new highs?