The affect Risk Profiles have on Portfolio Performance

Last week’s post on volatility raised a number of issues about risk profiles and the levels of exposure different investors have had to the bear market we are currently experiencing. In light of the questions and comments we have received I thought that I would discuss the five SPA3 Risk Profiles and the differing effects they each have on a portfolio’s performance.

I have shown in the figure below a chart of the ALL ORDS from mid 2004 until November 21 2008. You will notice the red and green symbols on the chart that represent when SPA3 indicates a change to LOW market risk (green symbol) or HIGH market risk (red symbol). This change happens dynamically in line with the market as it changes direction. Once a signal appears, SPA3 traders go about acting as mechanically as possible to their planned risk profile, which they have detailed in advance in their personalised SPA3 trading plans. The changes in market conditions indicated by the green and red symbols also have a long term influence on position sizing. In the short term the first priority for each investor is to determine their SPA3 Risk Profile and thus how and if they will reduce exposure to the market during periods of high risk and/or bear markets.

The five risk profiles differ, as do each of us as active investors. Someone coming to the market for the first time and at retirement age may have a different objective than that of an experienced trader of 20 years. Drawdown in a portfolio can also affect the psychology of an investor and a more conservative approach maybe considered. The capital available to individual investors will also influence their outlook about the market – someone beginning with equity of $80,000 will have a completely different approach to that of someone with a much higher amount of starting capital. These are just a few examples of the differing personalities that individual investors bring to the market.

The effect a pre-chosen risk profile will have on a portfolio will vary based on the exposure of capital one has to the market. I have listed the five SPA3 Risk Profiles in a simple easy to understand explanation of the strategy.

RISK PROFILE 1 (lowest risk strategy – suitable for the highly risk adverse investor)
When a HIGH market risk signal (red symbol) occurs the investor will automatically close all positions in the portfolio; this will take the investor 100% into cash. The investor will remain in cash until a LOW market risk signal (green symbol) occurs; at which time the investor will engage the market again by taking the buy signals generated by the SPA3 system.

RISK PROFILE 2
The SPA3 public portfolio is traded using Risk Profile 2. Risk profile 2 allows the investor to stay 100% invested in the market as a high market risk signal appears. The investor will wait for exit signals to be generated by the SPA3 system for the individual stocks within their current portfolio. Money management rules will stipulate that all new stock entries will have rediuced position sizes upon entry. If the market is high risk the new position size will be reduced by 33%. If the stock also appears in a high risk sector then the over all position size will be reduced to a maximum of 50%. This is not only done mechanically with the SPA3 tools but occurs dynamically at the time the risk profile of the market changes.

Using Risk Profile 2 might take a few weeks to reduce exposure to the market to 50% invested and 50% in cash, depending on market conditions. In the chart above note where the high market risk signals occurred during 2005 to 2007. In the rising market Risk Profile 2 would have been mostly invested during high market risk periods therefore achieving better performance than Risk Profile 1.

RISK PROFILE 3 and 4
Risk profiles 3 and 4 require the investor to stay 100% invested 100% of the time regardless of the market and sector risk of the buy signals generated. Some lightening of open positions occurs when the market changes to high risk. All new buy signals are entered using a full position sizing model.

RISK PROFILE 5 (highest risk strategy)
This profile requires the investor to stay 100% invested 100% of the time regardless of market risk, sector risk, or overall market conditions. It continues to take all new buy signals at full position size and ignores the signals to lighten or reduce position sizes in a high market risk environment.

SUMMARY
Whichever risk profile is choosen you must be aware that it will influence the results of a portfolio’s performance. Risk Profile 1 clients have performed extremely well compared to the overall market recently as it has been in a sharp and extended down trend as they have been 100% in cash for just about the entire bear market and have therefore greatly reduced drawdown by having no exposure during the recent high market risk periods.

In an up-trending market Risk Profile 1 will under achieve compared to Risk Profiles 2 to 5. Under these conditions, the down moves are much shorter and the market bounces back quite quickly, leaving the low risk investor out of the market until a green LOW risk signal occurs. This can often result in this investor waiting in cash for some time whilst the other risk profiles are back in the market enjoying some wonderful early gains in share prices as the market turns up again.

During extended downtrends and periods of high risk, the higher risk profiles will under perform those who have moved 100% into cash or mostly into cash. There is always a trade-off and each investor MUST decide well in advance which trade-off they will choose and commit it to their Trading Plan before engaging the market. Is it to miss out on the early gains when the market turns while they remain in cash (Risk Profile 1), to continue probing the market in search of profits with reduced exposure and suffer drawdown although far less than the market (Risk Profile 2), or to continue all guns blazing regardless of market or sector risk (Risk Profiles 3,4 and5)?

The choice of Risk Profile 1 will result in much lower returns over the LONG term. It will be a great choice during prolonged downtrends such as we are now experiencing. In the end however, the returns from the other risk profiles will be much greater. Returns from investing in equity markets far outperform returns from investing in cash over the long term. The log chart below shows the returns of a SPA3 portfolio using Risk Profile 2 when compared to the All Ordinaries Index and cash returns over 7.8 years from January 2001. Notice the % Invested chart which shows portfolio exposure increasing and decreasing over the life of the portfolio.

I encourage traders to choose the risk profile that you believe best suits your investing style and then document it in your Trading Plan. Ensure that you fully understand the workings and ramifications of that decision and then avoid the temptation to chop and change too much. If you choose a Risk Profile that is too risky for your personality you will find out when the market turns down. Make the necessary adjustment to your Tradig Plan and then continue engaging the market. The aim is to make decisions that can make future performance repeatable and allow you to engage the market consistently and confidently over the long term.

Next week I will discuss the benefits of running a low correlated strategy and at the same time introduce hedging into the mix.