Wednesday, April 20, 2016

Benefits of Model - Part 2

2. Less Stress During Volatile Markets

During times of extreme stock market volatility, investors either exit the market out of fear or stay in the market but don't look at their portfolio. Others keep looking at their portfolio and hope that market rises so that they can make-up for losses.

However, model's low correlation with the market ensured that the stress level was significantly reduced during the volatile market moves. Furthermore, it allowed us to withstand market gyrations without making panicky decisions. As a result, model remained invested throughout the downtrend and ensuing rally.

3. Eliminating Emotions

Reduced stress improves the decision making ability. It allows the investor to see the forest from the trees. As panic decisions are avoided, big picture objective investment ideas emerge. Since investments are governed by business rules, systematic approach helps in eliminating emotions from investment. 

One of the key drivers of this reduced stress and minimal emotional interference during market volatility is diversification of portfolio holdings.

3. Diversification

Diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets.

Creating a truly diversified portfolio requires a lot of effort and capital because diversification needs to be performed across stocks to avoid business risk i.e. minimizing the risk of a certain company getting out of business or committing earnings fraud like Enron. However, stock diversification does not address market risk. 

Market risk is addressed by diversifying across asset classes. But asset class diversification again requires significant effort and capital. In other words, this diversification can add a lot of value to the portfolio

In this regard, the Portfolio Enhancement Algorithm has automated diversity through minimum effort and capital usage. This allows us to minimize risk, reduce volatility and have a well diversified portfolio along the way.

We will continue to analyze the model based on Q1 performance and some of the key benefits. Following items will be discussed in the upcoming posts:
  • Trend/Momentum following ability
  • Buy and Hold features
  • Positioning for next market move
  • Quantitative benefits:
    • Beta
    • Sharpe Ratio
    • Alpha

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