Risk vs reward measures are typically used for performance evaluation of a strategy or portfolio. But what does risk really mean? Presumably we're talking about risk of loss. But risk of loss means that you actually exit a position at a loss. So really, then, we're talking about the risk of making a decision to take a loss. That means to measure risk using a statistical measure of past prices, like standard deviation (used in sharpe ratio) or negative semi-deviation (used in sortino ratio), you're ignoring any behavioral economic aspects in making that decision.
The implicit assumptions in using a price-derived statistical measure of volatility in a performance evaluation are (1) that we make decisions at fixed-width intervals (because the mathematical definitions of those measures use such intervals), (2) that measure is the same in the past as it will be in the future, and (3) average return compensates for having to tolerate the volatility in real time.
Assumption (1) depends on the freedom of investors (or portfolio manager) to withdraw funds or exit positions. (2) is definitely false, and generally just used for convenience. My main focus for a new measure of risk is on (3). The average return is the best estimate of future return, given that the future is unknown. But surely risk tolerance is path dependent. It's one thing for a portfolio to be up one day, down the next, for e.g. 30 straight days. And it's another for a portfolio to be down for 15 consecutive days, then up for 15 consecutive days; that may incur different behavioral economic aspects for investors. Many risk models assume that prices have no memory, but investors surely do have memory. And no matter what the average or expected return is, I would argue that it's the Probability(return will be x% greater than a volatility-free portfolio) that matters most. And that probability may depend on factors other than the statistics of past prices. Surely neuroeconomics will bring us to a new definition of risk, which does a better job of measuring how we anticipate future outcomes.
The managed macro portfolio is +5.4%, with its worst drawdown at -2.56% on May 15. The drawdown was 1 day after I moved to full leverage, so clearly I was not worried about the possible volatility. If I had outside investors, I would have told them that the probability of having a good return within 1-3 months was 100%. I said over a month ago that the russell will rally back to 1200, that the dax will get to 10k, and they are on their way. The stock market will continue higher this year, with a few bumps and detours along the way, to be sure. As Laszlo Birinyi says, it's like driving from NY to LA. You're sure to get there, and don't sweat the possible traffic or flat tire along the way.
Monday, May 26, 2014
Saturday, May 3, 2014
1987 vs 2014
The market has moved roughly sideways, the PL in the model portfolio for the first 3 days has been (+63K, +15K, -20K). Most of the gain was due to entering mid-day before the FOMC announcement. I have no special knowledge about the Fed or any geopolitical events. I use my best judgement based on the aggregate experiences I have accumulated over the past 20 years.
Some market analysts / portfolio managers are looking for some sort of big market crash in the near future. It's possible, it's always possible, that's the nature of financial markets. I've listed all the known unknowns I can think of in a previous post. Today I will make some comments about 1987 vs today.
This is not 1987, this is not 2000, this is not 2008. This is 2014, and as far as I can see today, we are in a stable uptrend / bull market. There are selloffs in a bull market, and every one is an opportunity right now. Leverage must be managed, of course. Any incidence of over-leverage can destroy any strategy based on a correct analysis of the markets. Now, 1987 was the fifth year after a very strong rebound from the 1981-82 recession. The US economy was moving from fast growth and high inflation to slower growth and low inflation. This year, 2014, is the fifth year after a very weak rebound from the 2008 "Great Recession." We have had low inflation for some time, and obviously interest rates are much lower than in 1987. The Dow Jones moved from 1895 to 2722 in a matter of 7 months in 1987, peaking in August. The 10-yr Treasury rate moved from 7% to 10% between April and October 1987, after having moved down over a long stretch in the early and mid-1980s. It's interesting that the SP500 this year has pushed up near 1895 twice, with yet to break and stay above that level. It may soon, unless events unfold to derail the trend.
Additional events from 1987 were some geopolitical events in the middle east, with Iran firing a missile at a US built ship called Sungari. There were no casualties, and the ship did not carry a US flag. Therefore the US made no retaliation, only saying something to the effect that it was an attack on Kuwait. Of course, 3 years later, Gulf War I unfolded. Portfolio Insurance was a new fad back in 1987, which is said to have contributed to the size of the selloffs in October of that year. There was "program trading," which of course is always out there now, with the added uncertainty of "high frequency" and a "flash crash" as in May 2010.
Everyone knows the geopolitical events going on now, and as I've said in previous posts, there are lots of strategies and groups that will add to volatility on that score. Sometimes that allows the markets to climb a "wall of worry" and march higher. I stand firmly in that camp at present.
Some market analysts / portfolio managers are looking for some sort of big market crash in the near future. It's possible, it's always possible, that's the nature of financial markets. I've listed all the known unknowns I can think of in a previous post. Today I will make some comments about 1987 vs today.
This is not 1987, this is not 2000, this is not 2008. This is 2014, and as far as I can see today, we are in a stable uptrend / bull market. There are selloffs in a bull market, and every one is an opportunity right now. Leverage must be managed, of course. Any incidence of over-leverage can destroy any strategy based on a correct analysis of the markets. Now, 1987 was the fifth year after a very strong rebound from the 1981-82 recession. The US economy was moving from fast growth and high inflation to slower growth and low inflation. This year, 2014, is the fifth year after a very weak rebound from the 2008 "Great Recession." We have had low inflation for some time, and obviously interest rates are much lower than in 1987. The Dow Jones moved from 1895 to 2722 in a matter of 7 months in 1987, peaking in August. The 10-yr Treasury rate moved from 7% to 10% between April and October 1987, after having moved down over a long stretch in the early and mid-1980s. It's interesting that the SP500 this year has pushed up near 1895 twice, with yet to break and stay above that level. It may soon, unless events unfold to derail the trend.
Additional events from 1987 were some geopolitical events in the middle east, with Iran firing a missile at a US built ship called Sungari. There were no casualties, and the ship did not carry a US flag. Therefore the US made no retaliation, only saying something to the effect that it was an attack on Kuwait. Of course, 3 years later, Gulf War I unfolded. Portfolio Insurance was a new fad back in 1987, which is said to have contributed to the size of the selloffs in October of that year. There was "program trading," which of course is always out there now, with the added uncertainty of "high frequency" and a "flash crash" as in May 2010.
Everyone knows the geopolitical events going on now, and as I've said in previous posts, there are lots of strategies and groups that will add to volatility on that score. Sometimes that allows the markets to climb a "wall of worry" and march higher. I stand firmly in that camp at present.
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