## Financial Planning

Investors want to achieve a sustainable income during their lifetimes (especially during retirement), by investing their savings.

The problem is that markets are unpredictable and often too volatile. Historically, during the last 20-years, stocks have delivered returns **varying widely between 2% and 18% per year. The maximum loss during 2008 was 60% and during 2000 was 35%.**

To resolve this uncertainty, investors should select investment strategies which generate **sustainable profitability with low volatility**. **Volatility** describes the degree to which an asset’s price moves up and down. **Volatility describes the investment’s risk**. Usually, during periods of high volatility, asset returns tend to be lower and during low volatility asset returns tend to be higher. When an asset’s volatility spikes, it often leads to big asset losses.

The most important factor in **creating long-term wealth growth**, which supports sustainable retirement income, is investing in portfolios which generate consistent returns and avoid big losses and **high volatility**. The aim is to take advantage of **compounding** (image below).

**AssetMacro Asset Allocation Strategies** have achieved consistent profitability, with low risk, by adapting dynamically to different market and economic environments.

## Investment Analysis Principles

The most important mistake amateur investors make is they select investments based only on their past **short-term returns while ignoring the key factor of risk experienced**.

To examine an investment’s performance, you must analyze the following characteristics:

**Annual return** Average annual return (AAR) is the percentage historical return of an investment. Typical Fund average returns are 5-10%.

**Volatility** Volatility describes the degree to which an investment’s value moves up and down. This is the investment’s risk.

**Tip:** Investors should select investments with the **highest return possible and the lowest volatility**. The aim is to grow wealth by taking advantage of **compounding**.

**Maximum Drawdown** A strategy suffers a drawdown when it loses money. Max drawdown measures the largest single drop from peak to bottom in the investment’s value. Investors in a fund with a max drawdown of 50% saw their portfolios lose half of their value.

**Tip:** Investors should select investments with the lowest possible maximum drawdown. Big Losses must be avoided because it’s very difficult to recover from them. A 50% loss requires a 100% gain to get back to even. Investments with Maximum Drawdown between 5% and 20% are considered safe investments.

**Performance Consistency** An investment’s performance should be examined for long historical periods of at least 10 years to confirm how an investment performed during different market environments (Growth, Recession).

**Market crashes** Special attention must be given on how the investment performed during market crisis like 2000 dot-com bubble, 2008-2009 crash.

**Tip:** Longer periods of historical performance often guarantee similar future investment performance irrespective of the market environment.

**Sharpe Ratio** Sharpe ratio shows how much return you get for every unit of risk taken.

**Tip:** Good safe investments generate Sharpe ratios between 1.0 and 2.0

**Investment Costs** An investment’s **net** performance must be examined after all costs have been deducted.

**Tip:** The higher the cost of an investment, the greater the erosion of an investor’s returns is and hence the more difficult it is to generate profits.

**Asset Selection & Diversification** The assets an investment utilizes must be thoroughly examined. The asset selection must fulfill the concept of diversification. Individual assets have hidden big risks that amateur investors won’t recognize (e.g. Enron, Lehman Brothers collapses, General Motors Bankruptcies).

**Tip:** A well-conceived **diversified portfolio of uncorrelated assets** has the potential to perform much better than investing individually in the assets themselves only.

## Asset Allocation: Step By Step

**AssetMacro asset allocation strategies** aim to generate good stable returns, with low risk. To achieve this, they are structured to be flexible and to adapt to different market and economic environments. Asset Allocation strategies are build based on the following methods:

**Portfolio Asset Selection**: Assets of our portfolios are selected based on their behavior to all economic and market environments and their dynamic correlations (**Correlation** is measurement of how similarly one asset behaves in relation to another.).

**Momentum**: The Asset Allocation in our **AssetMacro simple momentum portfolio** is adjusted using simple momentum methods. These are quantitative methods which monitor each asset’s momentum and decide whether to keep it in the portfolio or not.

**Balancing Portfolio Volatility**: The Asset Allocation in our **AssetMacro balanced portfolio** is adjusted using **momentum** and **risk parity** methods. These are quantitative methods monitor every asset and adjust each asset’s weight on the Portfolio Allocation.

**Advanced Optimization Methods**: These are advanced quantitative optimization methods which use advanced momentum methods and adjust portfolios’ asset weights based on volatility, correlation and minimum variance optimization algorithms.

## Portfolios’ Asset Selection

The assets selected to structure portfolios is the most important decision an investor should take. **Balanced portfolios** use assets, which are **not highly correlated to each other** (**Correlation** is measurement of how similarly one asset behaves in relation to another.), in order to generate good returns, with low volatility, in all market environments.

AssetMacro asset allocation strategies include assets which perform well, under each of the 4 economic environments, the global economy experiences. The assets used to build the AssetMacro portfolios are: **US Stocks, US Treasuries Bonds, Emerging Market Stocks, US Real Estate, Commodities, Cash and Gold**.

The assets of our portfolio are represented by the following high quality Exchange Traded Funds (ETF): 1. **VTI** (US Stocks), 2. **TLT** (US Long-Term Bonds), 3. **EEM** (Emerging Stocks), 4. **ICF** (US Real Estate), 5. **DBC** (Commodities), 6. **SHY** (Cash), 7. **GLD** (Gold).

**Investment Assets & the 4 Economic Environments**

The global economy is described by 4 global economic environments. 2 combined factor are used to define each environment: **inflation and economic growth**.

**The most important Asset Relationship: Stocks versus Bonds**

Stocks and Bonds are the 2 main pillars of all professional portfolios. Each of the two assets perform well during different economic conditions.

When **economic growth is high and inflation is rising**, stocks generate good consistent returns. At the same time, rising inflation is the worst possible economic environment for bonds.

On the contrary, **when economic growth is slowing and/or inflation is falling** or at the extreme cases that economic recessions, depressions and market crashes are experienced, long-term US bonds is the best performing asset, generating good returns with low volatility.

**Historical Analysis:**

Since the Great depression in 1929, investors in the United States have experienced 24 years of negative stock market returns. During all periods, US Treasury Bonds protected investors from capital loss and served as a flight to safety. In 19 out of 24 years US Treasury bonds generated positive returns.

## Momentum Portfolio

**Momentum** is one of the largest market inefficiencies generating consistent returns. The fundamental reason is that humans usually choose to follow the crowd rather than act against it. This causes rising prices to attract buyers and falling prices to attract sellers. Academic research has shown momentum to be a market anomaly from the early 1800s up to the present and across nearly all asset classes.

*“Cut your losses; let your profits run on”* – David Ricardo, 1838

**The most important Asset Relationship: Stocks versus Bonds**

There are many quantitative methods to apply momentum to an asset or portfolio. Our simple Momentum portfolio applies momentum as follows:

The Portfolio consists of the following assets: US Stocks (VTI), US Bonds (IEF), Emerging Stocks (EEM), US Real Estate (ICF) and Commodities (DBC)

Each asset (VTI, IEF, EEM, ICF, DBC) holds an equal weight to the portfolio (20%)

At the end of every week, the algorithm calculates each asset’s previous 1-month (20 trading days) return:

- If the return is negative or zero, we substitute the specific asset with cash (SHY).
- If the return is positive, we keep the asset in the portfolio or we buy the asset if we do not already hold it.

**AssetMacro Momentum Strategy Performance**

The **AssetMacro Momentum Portfolio** generated impressive given its simplicity. The portfolio generated three times the risk-adjusted returns of the US Stock market.

The portfolio’s average annual return was 11% when the US stock market’s return was 6.4%. A 56% improvement in returns was achieved with half the US Stock market’s volatility.

Moreover, the Simple Momentum portfolio lost a maximum of 12.30% during it’s worst performance while the US Stock market lost 59% which is almost 5 times more.

**Hover to view Portfolio’s Monthly Returns Analysis**

## Balanced Volatility Portfolio

The goal of risk parity is to build a **balanced portfolio**, which will generate stable annual returns with lower risk, than the same portfolio with equal weight among assets.

Risk parity ensures that each asset in the portfolio contributes an equal amount of risk (volatility) to the portfolio. Each asset’s weight in the balanced portfolio is calculated based on the amount of the asset’s recent volatility as compared to the volatility of the other portfolio’s assets.

**Volatility Definition**

Volatility describes the degree to which an asset’s price moves up and down. Recent volatility of an asset can be estimated by calculating the recent (trailing) 20-day standard deviation of the asset’s returns.

**Balancing Volatility Example**

The aim is to build a balanced portfolio, with only stocks and bonds and assign equal risk contribution to both assets. The recent volatility of stocks is 2 times (200%) the observed volatility of bonds. The appropriate allocation to each asset would be computed as follows:

*Allocation to stocks x volatility of stocks = allocation to bonds x volatility of bonds Since ratio of volatility of stocks: bonds is 2:1, the allocation would be equal 1:2 that is 1/3 stocks and 2/3 bonds*

**Building the AssetMacro Balanced Portfolio**

The **AssetMacro Balanced portfolio** is structured as follows:

The Portfolio consists of the following assets: US Stocks (VTI), US Bonds (IEF), Emerging Stocks (EEM), US Real Estate (ICF) and Commodities (DBC)

- The Portfolio consists of the following assets: US Stocks (VTI), US Bonds (IEF), Emerging Stocks (EEM), US Real Estate (ICF) and Commodities (DBC)
- At the end of every week the portfolio is structured based on the following calculations:
- Each asset’s recent 1-month (20 trading days) return is computed
- If the return is negative or zero, the specific asset is substituted with cash (SHY) and is allocated 20% of the portfolio’s weight, otherwise the asset is kept in the portfolio
- If the return is positive, the asset is held in the portfolio or is bought back if not already included in the portfolio

- Each asset’s recent 1-month (20 trading days) standard deviation is computed. The risk parity formula described above is used to calculate the weights of the portfolio’s assets. The risk parity formula takes into account each individual asset’s volatility versus the volatility of the rest of portfolio’s non-cash assets

- Each asset’s recent 1-month (20 trading days) return is computed

**Balanced Portfolio Performance**

The **AssetMacro Balanced Fund portfolio** generated impressive results while been very simple. The portfolio generated four times the risk-adjusted returns of the US Stock market (Sharpe Ratio of 1.20 versus 0.31 of US Stock Market).

The portfolio’s average annual return was 8.6% when the stock market’s return was 6.4%. Most importantly, the AssetMacro Risk Parity portfolio lost a maximum of 7.2% during its worst performance while the US Stock market lost 59%, 8 times more! This can be viewed clearly from the lower chart above where in blue is the maximum loss of the risk parity portfolio and in orange the maximum loss incurred from the US Stock market.

AssetMacro **Balanced Fund** portfolio has successfully protected its investors while offering consistent returns during the last 10 years.

**Hover to view Balanced Fund’s Monthly Returns Analysis**

## Portfolio Optimization Algorithms

**Minimum Variance Optimization**

Default risk parity assumes that all assets have a correlation of zero. In reality, assets’ correlations are dynamic and almost never zero.

Assets which are highly correlated in the portfolio contribute much more risk than assets that are good diversifiers.

**Minimum variance optimization** algorithms strive to find the perfect weights of all assets in a portfolio by estimating dynamic volatilities and correlations between portfolios’ assets. These algorithms and consequently the portfolios utilizing such methods offer flexibility and short response times to changing market conditions.

Keep in mind that a good diversified selection of portfolios’ assets is a prerequisite for such algorithms to succeed in finding the optimum balance between assets.

**Flexible Portfolio Leverage**

To improve the portfolio’s performance further, portfolios’ returns can be enhanced further using dynamic methods to increase portfolio leverage when markets are calm and volatility is low. This occurs typically in the early and mid-stages of bull markets. When volatility is high which is in early stage of bear markets portfolio leverage is scaled down dynamically.

**Enriching the Portfolios’ Asset Selection**

Other assets can be included in the portfolio in order to broaden the portfolio’s spectrum monitored. In this way, returns can be boosted further while maintaining low levels of volatility.