2020 only just started. But for many stock investors, it may seem like an eternity. Just 3 days into the new year, a dreaded piece of news greeted the markets.
The United States assassinated a top Iranian General sparking fears of an all-out-war between the two countries.
That sent the global stock markets tumbling sharply momentarily. And just when markets looked set to recover, the Wuhan coronavirus that was first reported in December 2019 showed rapid signs of spreading in China and beyond.
This invoked memories of SARs in 2003, spooking the markets and setting off another wave of selling towards the end of the month.
Market Timing Does Not Work
I know I sounded all doom and gloom. But as far as the markets are concerned, are these anything out of the extraordinary? No.
But if such market moves unsettles you and makes you lose sleep, you are not alone. For those who holds the majority of their investments in stocks, this is a natural reaction.
Because we saw how much and how fast stocks can plunge in the past crises. Recoveries can be painfully long. And not everyone has the luxury of time on their side.
As a result, many went on a futile quest to master the elusive art of market timing which often ends up worse than not doing anything.
Unless you think you are smarter than everyone in the market out there, my advice: Don’t try to be a fortune teller and second guess what the market will do.
Building An All Weather Portfolio
So is there no way out of this fix?
If we want higher returns, then we have no choice but to stick with stocks, ride it out and bear the risks?
There are more efficient and safer ways to generate returns. And simple ones too. One such strategy is called Risk Parity which I talked about in an earlier post. Rather than timing the market, it works based on 2 commonsensical principles.
- Select assets that are fundamentally different and complementary.
- Pit an asset against another. Make use of their own innate behavior. Stocks and bonds are a good example. This ensures a higher chance of weathering through a crisis since it is much less likely that all asset classes will be hit at the same time. And as long as all assets appreciates in the long run, your portfolio will grow steadily.
- Distribute the risks evenly across all the assets.
- If you can’t predict what is going to happen, the most logical and best bet is to make sure all your assets are evenly matched in risks. So no single asset will dominate the portfolio performance even if it is hit by a catastrophic event. As market changes, so does the risks across the assets. Hence, the portfolio is rebalanced on a periodic basis to make sure that all risks are equally represented.
Putting Risk Parity To The Test
The strategy is adapted from what we used to run professionally in the fund, but scaled down for individual investors (fund has a bigger capital requirement).
It delivers a decent return with significantly lower risk than a 100% stock ETF such as SPY. This gives us a lot of scope to amplify the returns further through leverage i.e. borrowing capital.
The table shows you the back tested performance of the 1.7x Risk Parity portfolio against SPY from 2005-2020 (transaction, slippage and financing costs are factored). During this period, Risk Parity is able to deliver almost 12% CAGR against 9% for SPY. And despite using leverage, it still operates at a lower risk both in terms of volatility and historical losses (maximum drawdown).
What is also worth highlighting is the robustness of such a portfolio during major stock crises. It loses significantly less and even delivers a positive performance during some of these trying periods (see bar chart below).
Since the inaugural course at the start of Nov 2019, the Risk Parity portfolio performance performed steadily in line with expectations.
We are also now running the strategy alongside using real funds. It was put to a new test this January and came up well.
While global stock markets headed south, the risk parity portfolio bucked the trend and rose approximately 3.6% in the month (note: performance may differ depending on the individual’s financing and transaction costs).
It is a good month to see the interplay between different assets. As risks escalates, stocks took the direct hit. In the meantime, safe haven assets ramped up, cushioning the blow and more.
That is how risk parity works, and this is how you can benefit from it.
- Masters of Science in Financial Engineering, NTU
- Masters (by research) in Engineering, NUS
- Bachelor of Electrical Engineering (1st Class) from NUS with Minor in Business, NUS
Eng Guan is a portfolio manager of a systematic hedge fund. He has extensive experience, having spent more than a decade in the asset management and banking industry working through various roles since 2006. These include performing investment due diligence on hedge funds, valuation control on derivative and structured products, proprietary trading and fund management.
Prior to all these, he started out his first career in the civil service in 2002. But it was also during this time that he developed a keen interest in the financial markets. This prompted him to make a mid-career switch and his decision vastly open up his horizon on the investment landscape. There was so much more beyond just picking stocks, reading analyst reports or financial statements. An engineer by academic background, he always had a strong passion and interest for models and systems. That naturally led him to pursue the systematic or data driven approach towards investing.