In our last post, we asked the simple question of whether an investor is better off being diversified if he or she doesn’t know in advance how a stock is likely to perform. We showed some graphs that suggested diversification lowered risk (or, more precisely, volatility), but this came at the expense of accepting less than maximal returns. We then showed that a diversified portfolio was able to produce better risk-adjusted returns on 8 out of 10 of the stocks we had randomly generated.
“Diversify, diversify, diversify!” Mantra, call-to-arms, or warning. Whether you’re an amateur or professional, a student or professor, a pedestrian or pundit you’ve been told that diversification is patently good when it comes to investing. Golly, it makes sense. Don’t bet it all black. Don’t own just one stock. Even grandma knows this. After all, she told you not to put all your egss in one basket. Then again she also told you about the Easter Bunny, who did just that.
In our last post, we discussed the potential for adding a tactical trigger to execute a strategy. In this case, the strategy is investing in a large cap stock index that allows us achieve a compounded annual return of 7% and limits the yearly deviation of that return not to exceed 16%, essentially an index roughly in line with the S&P500. As we noted, there was a 54% chance we might not make our total return goal.
In our last post, we defined the goal of an investment strategy, showed how comparing strategies may not be as straightforward as one would imagine, and outlined some critical questions that need to be answered when weighing competing strategies. In this post, we’ll look at what an investment strategy’s main constraints — namely, return and risk — actually imply.
What do the numbers say?
Assume you’ve chosen the strategy and assume it’s simple: invest in a large index of stocks, namely the S&P500.
Motivation
This string of posts is meant to help non-professional investors understand some of the complexities involved in choosing an investment strategy, suggest a logical framework on how to do just that, and offer different ways to analyze the data that motivate the strategies we’ll examine.
Strategies for the long run
Investment strategies and styles abound — from fundamental to quantitative to technical. For the professional investor how much credence one gives to each approach depends as much on education, training, and employer as on open-mindedness and opportunity cost.