A Market Timing Rule that Works
Nonetheless, many give the advice that one should allocate more of their wealth, proportionally, to cash as one gets older, a basic rule would be your age in years as a percent should be your bond allocation (eg, 29% for a 29 year old). While this advice is common, most academics find such recommendations misleading, as Robert C. Merton and Paul A. Samuelson have written numerous articles over the years arguing these are based on a misunderstanding about long-term data that just happened to work out well over the past 120 years in the USA.
I’m not addressing that argument, that one should allocate differently based on one’s investment horizon or level of human capital, rather, I’m focusing on the implication from the predictability of volatility. Consider the simple 10 day moving average implicit in the following variance forecast
EMAvar(t+1)=(1-λ)*ret(t)^2+λ*EMAvar(t)
With a λ=0.9, that’s about a 10-day exponential decay moving average. Now, with daily observations from the market return data from Ken French’s website (which has daily returns back to 1963), we get highly significant predictability. This fact underlies the usefulness of GARCH modeling of financial time series, and why Robert Engle won a Nobel prize for it. Volatility is eminently predictable:
In contrast, returns are not highly correlated with the volatility forecast (here data were bucketed into 20 groups sorted by the variance forecast):
There’s a weak correlation with arithmetic return for volatility forecast, and extremely weak for the geometric return. The simple implication is that you might be able increase your Sharpe by avoiding the really highly volatile times that offer no corresponding return premium. The key, as highlighted in Welch and Goyal, is whether this is one of those patterns that disappears in real time, in that ‘high’ and ‘low’ in the above graph is only revealed after seeing what happens; a useful rule looks at ‘point in time’ data that is not forward-looking, and this is were most rules fail.
- Invest 100% in equities if Ema(Variance)<[1.5*2 year rolling average of the Ema(variance)]
- Invest 100% in T-bills otherwise
- Only change allocation if you haven’t changed it over the past month
So, the Timing Rule generates a significant increase in the Sharpe ratio, from 0.25 to 0.43. With 33% of the volatility removed, it is comparable to ‘minimum variance portfolios’. That is, those approaches also can also reduce your volatility relative to passive strategies by 30-40%, without sacrificing total return (usually increasing it a couple percent). The max drawdown moves from 55% to 47%, which isn’t a lot, but the timing strategy missed a comparable loss in 2009, so more importantly the frequency of these 50%ish drawdowns was cut from 2 to 1.
Source:
Anyone can join.
Anyone can contribute.
Anyone can become informed about their world.
"United We Stand" Click Here To Create Your Personal Citizen Journalist Account Today, Be Sure To Invite Your Friends.
Please Help Support BeforeitsNews by trying our Natural Health Products below!
Order by Phone at 888-809-8385 or online at https://mitocopper.com M - F 9am to 5pm EST
Order by Phone at 866-388-7003 or online at https://www.herbanomic.com M - F 9am to 5pm EST
Order by Phone at 866-388-7003 or online at https://www.herbanomics.com M - F 9am to 5pm EST
Humic & Fulvic Trace Minerals Complex - Nature's most important supplement! Vivid Dreams again!
HNEX HydroNano EXtracellular Water - Improve immune system health and reduce inflammation.
Ultimate Clinical Potency Curcumin - Natural pain relief, reduce inflammation and so much more.
MitoCopper - Bioavailable Copper destroys pathogens and gives you more energy. (See Blood Video)
Oxy Powder - Natural Colon Cleanser! Cleans out toxic buildup with oxygen!
Nascent Iodine - Promotes detoxification, mental focus and thyroid health.
Smart Meter Cover - Reduces Smart Meter radiation by 96%! (See Video).