November 02, 2014

Thoughts on maximizing the permanent portfolio's efficacy - Part 1

As I move towards a permanent portfolio, there are a few aspects of it that despite the overall simplicity, need to be sorted.  Many investors may not realize how nuanced it can be, and these differences can make a large impact on returns.  However, one important thing to consider is that any single system will have better years and worse years than another system, even if in the long term both are comparable.

The things one needs to decide when following this investing style are the following:

1.  Rebalance triggers and/or frequency.

2.  Leverage, margin, and ETF optimization.

3.  Ratio of asset classes.

4.  Extra assets such as emerging bitcoin/virtual currency, oil, misc commodities.

Let's look at number one today.  Some options are rebalancing monthly, quarterly, or yearly.   I think monthly is much too soon, and if I do a regular rebalance, it will be once per year.  The reason is trends.  I'm still very much a trend follower mindset.  If an asset class is falling, your position size will shrink.  As it shrinks your exposure will decrease.  The opposite will happen with rising asset classes.  This has a positive performance bias towards trending markets.

You can also rebalance when the balance gets thrown off from strong moves in the asset.  However, using this as a trigger removes the above bias.  If gold falls 20% and I rebalance, and then it falls 20% again, I've lost more than if I just let it run.  Similarly if I sell some S&P500 after it rises 20%, and it rises 20% again, I've missed some gains.  In choppy or flat markets, more frequent rebalancing would benefit the bottom line.

What about technical rebalancing?  Alongside a yearly rebalance, an idea I've come up with is trend balancing.  While an asset is trending, leave it alone.  Once it has clearly reversed, rebalance that and only that asset.  Your criteria for a reversal will determine the likelihood of more or less frequent adjustments.  Rebalance only on reversals, not on initial or resumptive movements. 

Also, no matter what vehicle you use to capture the move, always use the moving averages, breakout levels, and stops of the underlying when possible.  I may use $UGLD to get three times the exposure to $GLD, but I will only use $GLD or spot price of gold for technical determination of reversals which would trigger a rebalance.  The reason being that tracking errors and volatility decay can degrade price of the vehicle.

I plan on using 120 day high and low for trend reversals.  It's very lazy, and will likely miss some moves, but it also prevents frequent rebalancing, which I think is an enemy of expected returns in this system.  In addition, the asset will be given 4 additional trading days to recover before considering the reversal confirmed.  As a final rule, the rebalance must be beneficial on the assumption of a trend reversal (increase of position size on 120 day high for example), and the imbalance must be 5-10%.  

I think this gives the system enough flexibility to follow trends and avoid over-reacting.

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