Diversification, Momentum And Risk

 

This article deals with diversification and momentum. It brings the two concepts together in a non-traditional manner. Our intent is to see if value can be created where:

Value is defined as higher return for the same amount of risk or lower risk for the same amount of return.

A brief review of where we have been follows.

Diversification

We looked at traditional diversification represented by a variety of weightings of two (diversified) assets — stocks and bonds. The results showed risk reduction but with pretty heavy penalties to returns.

A subsequent article looked at expanding the asset classes beyond generic stocks and bonds to see what could be accomplished. This more diversified portfolio improved over the previous work but still seemed unexciting.

After that, a simple moving average (SMA) was introduced. This technique, not considered diversification by most, produced impressive results. It is included here because it represented two assets, one a diversified collection of US Stocks and the other a diversified collection of US Bonds. In that sense, it was like the first attempt at traditional diversification mentioned above. What differed here is that you were only in one at a time, allowing market performance to dictate which and for how long.

The simple moving average (SMA) signaling switch produced superior results, both in terms of return and risk to the traditional approaches to diversification. One might think of it as a form of serial diversification.

Momentum

The last article looked at momentum as a way to invest. That article pointed out that a moving average works because trends, once begun, tend to last longer than Efficient Market Theory (EMT) predicts. In that sense, the SMA switch could be considered a quasi-momentum tool as well as a serial diversification tool.

The purpose of the previous article was to explore using past returns, the traditional momentum measure, to try to produce superior results. Higher returns tend to persist for longer than EMT predicts. Ten assets were ranked based on momentum and then the highest ones were purchased. Assets were held for a month and then the process repeated.

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