Wednesday, March 26, 2008

Smoothing the Ride Through Trading - Different Approaches

Roger Nusbaum often talks about "smoothing the ride" - trying to get stock like returns (or better) in the long run with a little less volatility in the short-run. There are a lot of ways to do this. The first and most obvious is to diversify beyond a stock only portfolio to include other asset classes that are relatively uncorrelated with stocks. Mebane Faber's blog has a lot of discussion of such approaches and combining them with some long-term trading to switch asset class exposures. However different asset classes will likely have different average returns. We can include lower returning assets and still maintain a higher overall return with the judicious use of leverage. As I've explained before, one approach is to apply leverage to stocks or real estate and, therefore, use less of your equity to get the desired exposure to these asset classes and then also include perhaps lower returning asset classes such as bonds to the portfolio (bonds have often returned stock like rates of return over significant periods but can't be expected to do so over say a half-century time scale).

Let's say you've constructed a portfolio something along these lines, what role can shorter term trading play?

We can categorize trading by how coupled it is to your investment portfolio:

1. Trading the Whole Portfolio If you listen to Cramer or read most online discussions about trading it seems this is the only way to go - you have to trade the entire portfolio all the time. After all, who wants to be exposed to a stock or sector that might be falling significantly? You only want to be in stocks or sectors that are going up, or you want to short the weaker ones. To my mind this approach is both tax inefficient - you lose out on discounts on long-term capital gains tax and taxes on dividends that many countries offer - and very high anxiety inducing. You have to be watching the market the whole time as something might happen which means you have to trade your portfolio.

2. Soros Style I was originally inspired to get into trading by reading The Alchemy of Finance. In the period discussed in the book, The Quantum Fund established a stock portfolio which was adjusted slowly and then borrowed against this core position to trade futures in a variety of macro-markets. Soros would develop hypotheses about what was likely to happen with currencies, gold, oil, bonds, stock indices etc, often in combination and put on trades to "test" these macro ideas. Early on I found that it is hard for an individual to do that kind of trading unless they are really full time at it and very talented. Yet a lot of people try. Again this seems a recipe for a lot of anxiety. There is always some trade, you have to be doing. You are trying to actively smooth out the troughs in the market with your trades - your stock portfolio is falling for example and you are trying to counter that in your macro-portfolio.

You could instead split your portfolio between a long-term investment and short-term trading sub-portfolios and invest in stocks in both, possibly farming out the long-term to other managers - this is getting more manageable, but there is in my opinion an even less stressful way to trade.

3. Alpha-Beta Separation You can in fact "smooth the ride" by trading without actively trying to smooth out the bumps. The key is generating returns from trading that are uncorrelated with the returns from your portfolio. Day-trading stocks, or currencies, or anything could qualify. This chart shows the MSCI index and a portfolio with beta of 0.82 and alpha of 9.3% over the last ten years:

Those are my estimated beta and alpha currently.* The portfolio is exposed to 82% of the market fluctuations in the short-run as well as a source of uncorrelated 9.3% annual returns - in practice I've derived these alpha returns from a variety of sources - including choosing skilled managers, gradually market timing the entire portfolio, and active trading. As you can see the addition of the alpha returns mean that though the portfolio is still volatile, the drawdowns are much smaller in percentage terms than the index. I think drawdowns (percent decline from peak to trough) are more psychologically important than volatility per se. The attraction of day trading is that once the day is over you don't (in theory) have to worry about the market. Your investment portfolio might get hit, but if you know that your trading can add returns that smooth the ride over the long-term you don't need to worry too much about that. I am trying to get to that psychological state. It's a struggle. I'm not there yet. Hopefully, I'm on my way.

* Unfortunately my alpha was much lower in the past and so I haven't had such nice gains :)

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