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Thursday, September 15, 2016

System 12. Performance and Risk

If you REALLY looked inside System 12 Portfolio I proposed in Portfolio Construction article of this series (post link), you will notice that all stocks in it are members of S&P500 Large Cap Index SPX. Moreover, they are the biggest components and affect index price action a great deal. To make sure of that I calculated an Index of Mega Dozen - MD Control - equal weighted portfolio of all 12 Mega Dozen stocks, regardless of any rules. MD Control uses fractional share count and doesn't account for commissions - so it is not an investable instrument, but a tracking tool. At times, there is a stock or two in MD that are not in SPX index. I found it to make no difference on MD Control relative performance in comparison to S&P. Originally I calculated it manually in Excel. On June 1, 2015 I set up MD Control as Motif here:
Below you will find a graph of Mega Dozen return since creation, where MD Control is blue line and S&P500 is green line. They track each other pretty closely, proving my original theory, that Mega Dozen actually Controls price movement of SPX. Really.
Based on back-test, simulation and real results, I still keep general projection of 20% profit annually, with average draw-down of 12%, but with much wider dispersion of results in a first year. Whether System is started during some kind of market correction and shows high profit from the get go, or all the buying is finished just before bottom drops out and sharp losses occur - system start is highly unpredictable. I found it very hard to forecast which one of scenarios is more likely to transpire, so it's always better to consider different outcomes and ... carry a cash reserve.

One of the biggest risks to the system is an abandonment during a period of under-performance. There will be stretches of few months when S12 shows nothing but losses. Every next trade is a stop-out, trading ledger is all red, with only open positions showing some gains (if any at-all). It is crucially important to stay the course, may-be reduce position size, wait a day or two, but maintain a system nevertheless. The other big risk is breaking the rules. There is no remedy for that.

System 12 focuses on absolute returns (meaning: I just want to make money), but it will act similar to S&P500 index most of the time, especially during bull rally. In fact, it often outperforms SPX, considering reinvested dividends, but this difference really felt only after the system is 'ON' for a year or more. Where System 12 really shines - is in avoiding big market-wide drops, that come out seemingly out of the blue, every year and sometimes more often. The S12 portfolio will not be able to completely eliminate the losses, but risk control measures will reduce portfolio somewhat prior to initial drop and liquidate most positions during bear market.

I was running System12 in 2014, and published "Mid-Year check" in this post (link). Red line on a chart is an actual portfolio balance - S12 real data, including commissions and dividends. Blue line is MD Control. Note, how red line dipped much less than blue in a beginning of the year, as positions were either stopped out or not initiated during market correction.
Shortly thereafter some positions were stopped out and I wrote here (link) on July 29: "Open positions of System 12 are light" (meaning there are less than 12 stocks in the portfolio), and how not having much to buy made me "a bit worried". Resolution came just a few days later with a drop on August 5: "I wasn't worried for nothing...he-he. System 12 is protecting itself, as it should..." Then in September 17 update post (link), I repeated that S12 was STILL not fully loaded, just before "whole market crap out" by about 10% in few short weeks.

In a spring of 2015 post (link) I found Mega Dozen "in a difficult condition, with half stocks either outright disqualified or unavailable", but by that time I already learned my lesson. From same post: "I remain very pleased with System12 performance. Risk control filters (designed for keeping me from buying Mega Dozen (MD) stocks during correction or in downturn) did just that - kept me away from bad risk. MD stocks are the biggest and the best, but its not written anywhere that they must remain to be so. Some will fall and never come back. I don't know which ones and when. I don't know the future. Really. I just know that System12 hasn't been fully loaded for months. I'm not arguing. I'm glad."
This condition persisted for remainder of the summer, and WAS a 2015 top! Pretty impressive...

System12 Rule #7 (post link) states that "portfolio can be partially or fully in cash for unspecified period of time" and is the basis for S12 Risk Management. This cash serves as a buffer during period of heighten volatility and gives an ability to 'buy the dip' when the time is right.

.this is a forth article in 'System 12' series.
Read Part 1: System 12. American MegaDozen. Introduction.
Read Part 2: System 12. Portfolio Construction and Rules 
Read Part 3: System 12. Trade Management 
-reading part 4-
Read Part 5: System 12. Portfolio Initiation

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