Diversification, Momentum And Risk

  1. Should the SMA be applied to only the one model or to both? The SMA switch was only applied to the market index. The rationale was that it was not used in the original momentum tests and would alter the outcomes from a model we wished to include based on its own performance.
  2. What should be the proportions between the two different approaches? Three different proportions were used in the backtesting process as can be seen below. There is no “right” mix. The choice is a personal and empiric one.

Tests were performed on data from 1998 through January 2019. The SMA Switching Index (SMA) was used as was the results of momentum selection (MOM) of 2 assets from ten used in the last article

Three different weightings were used in the testing:

  • Portfolio 1: 80% SMA; 20% MOM
  • Portfolio 2: 60% SMA; 40% MOM
  • Portfolio 3: 40% SMA; 60% MOM

The Results

The results of each test and the performance of the Vanguard 500 Index (a buy and hold strategy) are shown below:

DIVERSIFICATION AND MOMENTUM TESTS

 

The Interpretation of the Tests

The results clearly suggest there is value in combining the two approaches. Each of the three combinations outperforms the buy and hold strategy on both risk and return.

One might have expected the SMA portfolio to be less volatile than the 2 asset MOM portfolio. However, as the proportion of MOM increases in the combinations above, drawdown is virtually unaffected and return improves. This result seems counterintuitive, at least at first.

All portfolios beat the buy and hold strategy of the Vanguard 500 index and all do so handily and in every respect, especially with respect to maximum drawdown.

Caveats

These results were rather dramatic, but they still presumably do not satisfy risk-averse investors. An investor’s portfolio, following this strategy, now consists of three assets at any one time, a stock or bond index and two momentum selections.

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