Dynamic Portfolio Selection

When I first started to get in to systematic trading, I never sat easy on the fact that after the entire system was built based on objective sounds principles, the selection of portfolio to trade was subjective. How can the most important part of the whole process be left to discretion? Just like our stock forecasts never seem to pan out the way we want, I don’t think the selection of the portfolio based on our assumption that individual markets will continue to behave the same way will lead to anything accurate.

I went to look at Markovitz’s stuff and found it to be fundamentally thought provoking but technically counter-productive. I cant really say its a waste of time when millions (billions?) are managed this way. Lets just say their measure of risk is inherently flawed and keep it at that.

The Markovitz stuff lead to me to think further on minimizing correlation on the assets that I propose to trade. This made a lot of sense to me as if my system gave a signal on DJIA futures and S&P futures on the same day, it is unwise to take both. But the thing is correlation is ever-changing due to the fact that it is computed based on historical data and the results are not very reliable. (How many of you thought you were diversified enough during 2008..?)

Over at TB forum the other day, I landed on a idea that seems to be quite promising. It also took into consideration of many traders that have little capital. It conveyed the idea that a starting trader who has little capital to risk would inherently accumulate greater risk than starting traders who started out with a couple of million dollars in the futures market. This is caused by the fact that the small trader cannot use diversification to his/her advantage.

Solution: Predetermine the number of slots/positions (fixed) you would like to have. The number of slots is directly proportional to the amount of portfolio heat you can have if you have positions open representing each market in each slot. The only thing that can change is the markets that are in each slot. They can be replaced by new markets based on different criteria like liquidity, relative strength, trend strength, etc. This way you will only take the gist of markets based on your criteria for selection. Now instead of monitor your static bunch of markets you can monitor as many markets you want and only take signals from the ones that your criteria deems best.

Systematic Edge

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