In a sound asset allocation framework, it is never a good idea to over weight the risky portion of the portfolio. One example would be the traditional 60/40 portfolio whereby an investor allocates 60% to equities and 40% to bonds. Such allocation may intuitively makes sense as you “feel” diversified but when extraordinary events happen, you will be less protected. Below is the performance of the 60/40 allocation rebalanced monthly since 2003. Note I used SPY and IEF for the mix.
In this post, I would like to show some ideas that will reduce risk and increase return by bringing in a different type of return stream. Traditional asset allocation focuses mainly on optimal diversification of assets, here I will focus on allocation to strategies. From my own research, there are only so many asset classes the individual can choose to mix to form portfolios, not to mention the less than reliable cross correlation between assets classes in market turmoil (2008). To bring stability for the core portfolio, I will incorporate Harry Browne’s Permanent Portfolio. This return stream is composed of equal weight allocation to equities, gold, bonds. and liquid cash. For the more aggressive part, I will use daily equity mean reversion (RSI2). Note that a basic strategy overlay on an asset can produce a return stream that can have diversification benefits. Below are three different equity curves. Black, green and red represents, mean reversion, 60/40 equal weight allocation of both strategies, and permanent portfolio respectively.
To summarize, I have taken two return streams derived from strategies traded over assets and combined them to form a portfolio. The allocation percentage is 40% to the risk asset (mean reversion/MR) and 60% to the conservative asset (Permanent Portfolio/PP). And here are the performance metrics.
Traditional represents the traditional 60/40 allocation to equity and bonds while B-H represents buy and hold for the SP500. This superficial analysis is only meant to prove the powerful idea of equity blending of assets and trading strategies. When traditional search for diversification becomes fruitless, this idea of incorporating different strategies can have a huge impact on your underlying performance.
I will come back later for the R code as its pretty late and I have class tomorrow!