Diversification, Momentum And Risk

Backtesting results were dramatic both in terms of risk reduction and return enhancement. Results superior to all previously tested strategies were achieved. The optimum number of assets to select from the ten availablewas two, although all tested provided excellent outcomes.

Where Are We?

At this point, several basic approaches to investing have been explored. The best results were achieved (in the previous article) using momentum.

The best results were obtained from a two asset portfolio. It is doubtful many investors would be willing to trade a two stock portfolio, even if the two were themselves reasonably diversified.

Most investors are wisely grounded by the old adage of not “putting all your eggs into one basket.” That advice will be challenged, but not necessarily contradicted by future articles in this series.

From here we shall look at the effects of combining different methods of investing.

This first article will explore the combination of two previously investigated methods — Momentum and an SMA switch.

Diversification and Momentum

High volatility and high drawdowns, can be dampened by diversification. Often this diversification is costly in terms of what it does to returns.

The best returns seen thus fare are from the momentum selections. These also produced lower risk than traditional diversifications methods. The SMA switch also achieved more favorable outcomes than traditional diversification or buy and hold.

In this article, the effects of combining these two methods will be reviewed. Can we create value by creating a portfolio from two distinct methods of selecting holdings? Can we improve risk or return or both?.

The Test

The following represents holding part of your funds in the SMA model and the rest in the simple momentum selection model. Both models were discussed in detail in previous articles.

A couple of issues needed to be addressed to accomplish the combination:

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