Sunday, August 14, 2016

Robotic Investing Principles

Every hedge fund around has a philosophy in terms of how they approach earning excessive returns from the market.  Some do it through excessive leverage when making plays, some do it by going both long and short, and others through equity arbitrage (i.e. takeovers).

My approach is not too complicated; in fact I have attempted to make it as simple as possible.  Well, simple in terms of the strategies I use as opposed to complex finance tactics such as debit/credit spreads or index arbitrage.

If I went with a super simple strategy, I would buy a total market index funds, a long-term bond fund and be done with it.  That is not a bad strategy.

However, analysis of my behavioral makeup suggests I am not suited to a set it and forget it investing strategy.  I want more, and I am not happy unless I am trying to squeeze additional return from my portfolio.  That is what it is, and I have structured my portfolio to allow for that.

For example, I do use index funds where appropriate, however I use them within specific strategies I will write about on this blog.  I also trade volatility with the help of another site to capture some of the long term gains many have been able to achieve by trading XIV or VXX.

So what are the guiding principles that I use to run My Personal Hedge Fund?  The following are the key ones I use to guide all decisions I make withing my portfolio:

Principle #1: Use a Market Timing (gasp!) Rule

If you follow any type of mainstream investment advice, you will no doubt have heard that market timing is a fool's errand. From a short-term perspective that is 100% correct.  If anyone tells you they know what is going to happen in the market at any time, walk away because they are about to sell you some witchcraft.

My approach to market timing is only used to manage drawdowns, or excessive loss of capital when the general market goes down a lot.  I do not want to to be stuck in my investments when they are dropping 50-90%.

This means that I will from time-to-time sacrifice larger gains for reduced volatility in my portfolio.

How I do this is really simple.  If the S&P 500 (ticker = SPY) is trading above its 200 day simple moving average I will hold on to whatever positions I have, or invest more.  As of today, we are in an uptrend.  You can see how SPY is trading above its 200 day moving average (yellow line) in this chart:

Market Timing: SPY Trading Above 200 Day Moving Average (Yellow Line)

However, if the S&P 500 is trading below its 200 day simple moving average (i.e. in a down trend) then I sell and won't buy anything else.  This is what it would have looked like this past winter when all hell broke loose.  Using this simple rule would have had you sell when the SPY broke below the 200 day moving average.

This simple tool has saved me a lot of money as markets have been stuck in downtrends, like this past winter or worse in 2008.  If you want to learn more about this market timing method, be sure to check out Meb Faber's book Global Value or simply refer to Paul Todor Jones' comments about how he did this in 1987 and ended up making like 60% in one of the largest market declines in history.

Principle #2: Utilize Low Cost Index ETFs

One of the hardest thing to do is get returns greater than the market.  Ray Dalio says it best in Tony Robbin's book Money: Master the Money Game when he talks about his staff of hundreds and $millions$ of dollars spent on research in order to generate the types of returns he gets.

His advice is to invest in a solid asset allocation and stop trying to compete with the millions spent by the pros.  In other words, don't try to play hockey against Wayne Gretzky - you will lose.

That is essentially why I want to make sure I give my portfolio the best chance possible to at least get market returns at a very low cost.

A large portion of my portfolio is allocated to low cost index ETFs so that I get the returns the market is generating.

Even in the global portion of my portfolio where I invest in low-valuation countries around the world, I use index ETFs to give me the market returns.

Don't get me wrong, I do use individual stocks to grow my wealth, however that is only via specific strategies that buy a basket of stocks based on trend following methodologies.

Principle #3: Use Well-Research Strategies

I am pretty bad at picking individual stocks or knowing where the market is going to be tomorrow.  Actually I am terrible at it. Although I dabble in some very short-term trading (more on that in future posts) by picking strongly trending stocks, I try to stay away from the fundamental game of individual stock picking.

My approach to building My Personal Hedge Fund is to put together a number of very specific investment strategies that have been proven through well researched studies.  Studies from investment researchers like Meb Faber, Alpha Architect, and Research Affiliates.

It is not via the various FURUs (definition is here) on twitter or their stock picking services that offer their opinions on what works in the market.

As of today, my portfolio is built around some very specific strategies, including the following which you will gain insight to as I talk about them on this blog:
  1. Beat the TSX - a strategy that buys the highest yielding stocks on the S&P/TSX 60 (I'm Canadian so some of my investing is done up here!).  I use a spin on this by only buying a specific breakdown of the various business sectors to make sure I am diversified.  This strategy has been proven to beat the Canadian market over the years (not necessarily every year, but long term)
  2. Global CAPE - A large part of my portfolio buys index ETFs for countries that have a historically low valuation based on CAPE (Cyclically Adjusted Price-Earnings) ratios.  This strategy has proven to be very powerful in buying low priced countries that are in turmoil at their lows and riding them up as they recover.  This strategy has been proven to beat the S&P 500 over the years.
  3. US Index ETFs - I buy the US market by buying shares of SPY to get the S&P 500 and shares of QQQ, to get the NASDAQ market.
  4. Volatility - This is a very risky portion of my portfolio, however it can be very lucrative. This is the only strategy I use via a web site.  With this strategy I trade XIV/VXX to try to capture huge gains.  This is a very small portion of my portfolio.
  5. Trading - Although this is a very very small part of my portfolio, I have some funds set aside that I use to appease my urge to swing trade.  With this money I buy individual stocks from time to time using strict risk management principles.
Principle #4: Diversification via Global Allocation

Home country bias is a huge problem for investors.  That means that you probably invest the most of your portfolio in the country that you are from.  Here is a chart that demonstrates this fact:

If you couple that with the size of the various markets around the world, then you more than likely have your asset allocation all wrong (source).

The takeaway here, and how I structure my portfolio, is that I want to make sure that I don't focus too much on the US or Canada, but instead put a large percentage of my portfolio in markets outside of my local market.  Here is my asset allocation as it stands today (as of August 14, 2016):

Actual Allocation is >100% due to rounding!

Principle #5: Long-Term Focus

At the top of my portfolio tracking spreadsheet, I have the following words posted as a reminder that I am in this for the long-term. In other words, My Personal Hedge Fund is going to go up and down in the short-term but that will not let me waver from my approach.

It is so easy to read the FURUs on Twitter or get sucked into the slick sales messages from the hundreds of people on the web selling their own methods to getting rich.  A lot of these approaches will only transfer your wealth over to them through monthly fees.

Remember when I talked earlier about keeping your fees low; same thing applies here.  Don't go for short term performance at the expense of higher fees.  You will more likely end up poorer.


Well that sums up my approach, sorry it was so long.  I highly anticipate that I am going to refer back to this post a lot in the future.

Keep in mind, these principles may change from time to time, depending on life events.  As I get older, I have found my needs and principles required to run my hedge fund change.  Specifically, as new research is uncovered then I may apply that to my portfolio.  I would suggest that everyone does that, while at the same time being very careful not to get schizophrenic.  Nothing can kill gains faster (other than fees) than not sticking to an investment strategy.