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Investment Math

Apr 02 2011

Why Don’t We Use Short or Margin?

The title is one of the most frequently asked questions of our portfolios.

The simple answer we usually use is that over 90% of our managed accounts are IRA accounts, and we just can’t short stocks or use margin in IRA accounts.

Following is the actual elaborate answer for more sophisicated clients. Since risk is unlimited using short or margin and they could result in total account loss, it does not match our long term investment goal. Mathematically, as we can see from formula below, since Ls could be infinitely large with short or margin on stocks, over the long term (i.e, f is large) it is unlikely to make money if one keeps using short or margin.

Investment Gain = f * (Wp * Ws – Lp * Ls) where,
f = frequency of trades, e.g., trades/year
Wp/Lp = win/loss percentage
Ws/Ls = average win/loss size, Ls = R (i.e., Risk)

Over a smaller sample size, i.e., in the short term, it is possible to make money using short or margin with a few bets, but this is entirely different from our goal to use the same strategy over and over again for long term growth.

It may be easier to understand using a real life example. Let’s use GSIC to illustrate issue. As the chart below shown, in March, 2011, GSIC chart broke down a decenting triangle, has formed a series of head and shoulder, and was retraced back to $19 resistance level. Its fundamental valulation ratio is expensive (e.g., P/E at 47), earning is on the decline, so it looked like a perfect short setup, and stop loss can be placed at $20, with profit targets at $18, $16, and $14. The reward/risk ratio seems very favorable.

Assume one trader with a $5000 account, decided to take $500 risk to short 500 shares of GSIC at $19 and place a stop loss at $20. The trader also placed braket orders to cover 200 shares at the first profit target $18, and cover 200 shares at next profit target $16, and cover the last 100 shares at $14.

Right after the trader shorted GSIC with the perfect setup and placed all necessary orders to control risk, GSIC gapped up open at $29.41 next day with pending acquisition news, see chart below. So stop loss order was triggerd and 500 shares was covered at $29.41, with total loss more than $5200, resulting in total account loss.

It will probably take a long time to recover from such a trade.

Written by Hengfu Hsu · Categorized: FAQ, Investment Math

Feb 11 2010

How To Reduce Drawdown In Bear Market?

In the 2008-2009 bear market, all investment asset classes suffered significantly drawdown at the same time. In this global economy, investment bubbles are inflated and deflated at much faster pace and different asset classes become more correlated with each other, making it difficult to spread or reduce risk through allocation or diversification. Is any objective alternative to traditional buy-and-hold asset allocation/diversification scheme for the investors to reduce the pain during the bust cycle while participating the boom cycle when growth returns?

The 2006 paper “A Quantitative Approach to Tactical Asset Allocation” by Mebane T. Faber proposed a simple, price-only, non-optimized, yet elegant solution to above problem, and it proves to work beautifully in out-of-sample 2008-2009 bear market. Readers can use google to find the latest paper which is updated to include more out-of-sample results.

In previous post, it is shown the clear superiority of ^VAY index over any style, sector, country, or asset class. But like all other investment instruments, it suffered 60% drawdown during the 2008-2009 period, which is very difficult for any investor to swallow not to make emotional decision to give up long-term investment goal.

In this post, Faber’s approach is applied to the ^VAY index to see if drawdown can be reduced without hurting performance. Figure 1 shows the exact buy/sell points for ^VAY based on the Faber’s 10-month moving average technique.

Figure 1 shows that one would get out ^VAY at the beginning of August 2008 and re-enter the market at the beginning of May 2009. It clearly avoids the largest drawdown period of the bear market and captures a substantial portion of the initial bull market, just like it did in 2002 bear market.

However, there are numerous false signals creating unwanted whipsaws before both bear markets, making the technique difficult for less experienced investors to follow. Whipsaws from false signals are typical of price and volume-based technical analysis, since human fear and greed from reading news or rumors creates short-term irrational price and volume trading patterns that can’t be explained by mathematical formula (and are frequently taken advantage of by professional traders.) One simple way to avoid the whipsaws is to apply Faber’s technology to fundamental earning data, which is the true representation of the strength of the underlining market. Since there is no publicly available historical ^VAY earning data, Figure 2 shows the result of applying Faber’s 10-month moving average technique to historical SP500 earning (due to availability of data, quarter earning is used in 2000).

Comparing with Figure 1, Figure 2 clearly shows the whipsaws are greatly reduced since earning data shows steady deterioration months before crashes. Although SP500 earning is not necessary a good approximation to ^VAY earning, it serves the purpose of this post to explain the concept. To obtain better buy/sell points, it is possible to calculate the actual composite ^VAY earning from all companies in ^VAY index.

Figure 3 below compares the performance of ^VAY (blue line), with Figure 1’s price-based timing technique (red line), and with Figure 2’s earning-based timing technique (violet). After a sell signal and before a buy signal, the performance is calculated using cash without any interest. As expected, the performance of price-based timing technique suffers due to whipsaw during normal bull market, but is compensated during severe bear market. Earning-based timing technique outperforms the ^VAY by closely following the performance of ^VAY during bull market while avoiding most of drawdown during bear market.

Figure 4 compares the drawdown of ^VAY (blue line), with Figure 1’s price-based timing technique (red line), and with Figure 2’s earning-based timing technique (violet). Both timing techniques maintain the same drawdown size during bull market, but significantly reduces the drawdown during bear market.

In summary, the key to long-term investing success is to have an objective and unemotional strategy to reduce drawdown during bear market while participating the growth in bull market. The goal can be achieved by applying Faber’s technique to earning data of the underlining market to reduce bear market drawdown significantly without giving up the performance of bull market. Of course, stock market is very dynamic and dangerous, there is no guarantee that the experience learned from previous bear markets can be successfully applied into future.

Written by Hengfu Hsu · Categorized: FAQ, Investment Math, Investment Myths · Tagged: drawdown

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