If you follow the alternative investment landscape at all then you have heard of both risk-parity funds as well as CTA’s-Commodity Trading Advisors. Regardless of what you think of either strategy there is one thing that most investors should look at adapting to their particular style of trading/investing.
What “thing” am I talking about? Well the one component that most of them use in their trading process is to equalize the risk on each of their positions. Most CTA’s use a volatility based position sizing model of sorts while one of the goals of risk-parity is to bring each asset class up to the same risk level hence the parity in risk-parity.
In the case of a CTA they might use the last 20, 60, or 100 days to measure the volatility of the instrument. They might use standard deviation, average true range, or any number of other volatility based measures. Risk-parity funds tend to look at the long run historical volatility of an asset class. The time frame is of course dependent on their average holding period. Most risk-parity funds are relatively slow moving asset allocation shifts as volatility rises and falls while most CTA’s are medium term trend followers. So while a risk-parity fund might only adjust their allocations once a year a CTA could have 300% turnover in a year.
But while their time frames are different the ultimate goal remains the same. In both cases they are trying to normalize risk in an algorithmic fashion. This does two things. One is obviously to normalize risk across assets. The second is to take the human decision out of the equation. Both reasons have a lot going for them but I suspect that most investors would benefit from the second reason more than anything else.
In general humans tend to be over or under confident. When it comes to investing it is almost always hubris that hurts but in some cases it is still under confidence. By being as systematic as possible we can eliminate, or at least reduce, our bad tendencies while accentuating our good tendencies.
As an example I have always been far too risk adverse. I started off as a broker catering to very active traders. In this environment I saw a few people make a ton of money and a ton of people trade their accounts into oblivion. This experience made me very risk adverse and consequently my drawdowns have always been very small. The bad part of very small drawdowns is that it makes it that much harder to have very good upside. I always rationalized that “I will add more to the position later” when in practice that rarely happened. Over time I realized that if I doubled my drawdown size I would be fine and yet my upside would also double. To put this in perspective I have never had a -10% drawdown.
I always paid lip service to position sizing models but usually ended up taking 1/2 and sometimes even 1/3 of the suggested position. I have a solid risk management process but I was never maximizing my risk taking. Overly cutting off your upside is almost as bad as NOT cutting off your downside as they both lead to far less than optimal outcomes.
I finally decided I was done with that and worked out a position sizing algorithm that in theory I was happy with. I then committed myself to following it….no matter what. I now type in my volatility measurement, buy/short price, stop price, volatility measure and it spits out how big a position to take. My results have not only been far better but also more consistent and all this with drawdowns that are still tolerable. With my revised sizing regime I will eventually have a drawdown larger than -10% but barring some huge gap risk it should never be larger than -20%.
What I have seen across many investors accounts is that equalizing their risk, or at least really understanding how unequal risk is across positions, is a huge benefit to them. Take the traditional 60/40 stock bond portfolio. If you measure your risk you will see that you have far more risk in equities than the 60% would indicate. If you are really OK with this than fine but most investors….and even most of their advisors don’t even know this.
I could obviously go on and on about this topic and maybe will in a future post. In the meantime I would recommend that you go read up on risk-parity as well as CTA strategies. Whether you like their overall strategy or not is up to you-some people don’t want to lever up bonds to match their equity risk or go long/short soybeans-but they both have some systematic and very useful risk management concepts.
Finally I would say, just like half the industry would say, that the number one thing between many losing or at least under-performing investors/traders is a poor risk management and portfolio construction process. The word “process” sounds so cliche anymore and yet it is a real thing. If you don’t focus on process over outcomes then you will under-perform and likely lose money over time.