Last week’s post on volatility raised a number of issues about risk profiles and the levels of exposure different investors have had to the bear market we are currently experiencing. In light of the questions and comments we have received I thought that I would discuss the five SPA3 Risk Profiles and the differing effects they each have on a portfolio’s performance.

I have shown in the figure below a chart of the ALL ORDS from mid 2004 until November 21 2008. You will notice the red and green symbols on the chart that represent when SPA3 indicates a change to LOW market risk (green symbol) or HIGH market risk (red symbol). This change happens dynamically in line with the market as it changes direction. Once a signal appears, SPA3 traders go about acting as mechanically as possible to their planned risk profile, which they have detailed in advance in their personalised SPA3 trading plans. The changes in market conditions indicated by the green and red symbols also have a long term influence on position sizing. In the short term the first priority for each investor is to determine their SPA3 Risk Profile and thus how and if they will reduce exposure to the market during periods of high risk and/or bear markets.

The five risk profiles differ, as do each of us as active investors. Someone coming to the market for the first time and at retirement age may have a different objective than that of an experienced trader of 20 years. Drawdown in a portfolio can also affect the psychology of an investor and a more conservative approach maybe considered. The capital available to individual investors will also influence their outlook about the market – someone beginning with equity of $80,000 will have a completely different approach to that of someone with a much higher amount of starting capital. These are just a few examples of the differing personalities that individual investors bring to the market.

The effect a pre-chosen risk profile will have on a portfolio will vary based on the exposure of capital one has to the market. I have listed the five SPA3 Risk Profiles in a simple easy to understand explanation of the strategy.

RISK PROFILE 1 (lowest risk strategy – suitable for the highly risk adverse investor)
When a HIGH market risk signal (red symbol) occurs the investor will automatically close all positions in the portfolio; this will take the investor 100% into cash. The investor will remain in cash until a LOW market risk signal (green symbol) occurs; at which time the investor will engage the market again by taking the buy signals generated by the SPA3 system.

RISK PROFILE 2
The SPA3 public portfolio is traded using Risk Profile 2. Risk profile 2 allows the investor to stay 100% invested in the market as a high market risk signal appears. The investor will wait for exit signals to be generated by the SPA3 system for the individual stocks within their current portfolio. Money management rules will stipulate that all new stock entries will have rediuced position sizes upon entry. If the market is high risk the new position size will be reduced by 33%. If the stock also appears in a high risk sector then the over all position size will be reduced to a maximum of 50%. This is not only done mechanically with the SPA3 tools but occurs dynamically at the time the risk profile of the market changes.

Using Risk Profile 2 might take a few weeks to reduce exposure to the market to 50% invested and 50% in cash, depending on market conditions. In the chart above note where the high market risk signals occurred during 2005 to 2007. In the rising market Risk Profile 2 would have been mostly invested during high market risk periods therefore achieving better performance than Risk Profile 1.

RISK PROFILE 3 and 4
Risk profiles 3 and 4 require the investor to stay 100% invested 100% of the time regardless of the market and sector risk of the buy signals generated. Some lightening of open positions occurs when the market changes to high risk. All new buy signals are entered using a full position sizing model.

RISK PROFILE 5 (highest risk strategy)
This profile requires the investor to stay 100% invested 100% of the time regardless of market risk, sector risk, or overall market conditions. It continues to take all new buy signals at full position size and ignores the signals to lighten or reduce position sizes in a high market risk environment.

SUMMARY
Whichever risk profile is choosen you must be aware that it will influence the results of a portfolio’s performance. Risk Profile 1 clients have performed extremely well compared to the overall market recently as it has been in a sharp and extended down trend as they have been 100% in cash for just about the entire bear market and have therefore greatly reduced drawdown by having no exposure during the recent high market risk periods.

In an up-trending market Risk Profile 1 will under achieve compared to Risk Profiles 2 to 5. Under these conditions, the down moves are much shorter and the market bounces back quite quickly, leaving the low risk investor out of the market until a green LOW risk signal occurs. This can often result in this investor waiting in cash for some time whilst the other risk profiles are back in the market enjoying some wonderful early gains in share prices as the market turns up again.

During extended downtrends and periods of high risk, the higher risk profiles will under perform those who have moved 100% into cash or mostly into cash. There is always a trade-off and each investor MUST decide well in advance which trade-off they will choose and commit it to their Trading Plan before engaging the market. Is it to miss out on the early gains when the market turns while they remain in cash (Risk Profile 1), to continue probing the market in search of profits with reduced exposure and suffer drawdown although far less than the market (Risk Profile 2), or to continue all guns blazing regardless of market or sector risk (Risk Profiles 3,4 and5)?

The choice of Risk Profile 1 will result in much lower returns over the LONG term. It will be a great choice during prolonged downtrends such as we are now experiencing. In the end however, the returns from the other risk profiles will be much greater. Returns from investing in equity markets far outperform returns from investing in cash over the long term. The log chart below shows the returns of a SPA3 portfolio using Risk Profile 2 when compared to the All Ordinaries Index and cash returns over 7.8 years from January 2001. Notice the % Invested chart which shows portfolio exposure increasing and decreasing over the life of the portfolio.

I encourage traders to choose the risk profile that you believe best suits your investing style and then document it in your Trading Plan. Ensure that you fully understand the workings and ramifications of that decision and then avoid the temptation to chop and change too much. If you choose a Risk Profile that is too risky for your personality you will find out when the market turns down. Make the necessary adjustment to your Tradig Plan and then continue engaging the market. The aim is to make decisions that can make future performance repeatable and allow you to engage the market consistently and confidently over the long term.

Next week I will discuss the benefits of running a low correlated strategy and at the same time introduce hedging into the mix.

One of the major issues facing traders and investors in the current market climate is the extreme levels of volatility being experienced by all the world’s share market indexes. These extreme levels of volatility are also being experienced in almost all the world futures, currency and commodity markets as traders and investors of all shapes and sizes struggle to come to grips with what is being termed the global financial crisis. This has resulted in huge intraday price swings across all markets as fear and panic grip market participants. Normally level headed and balanced traders are even prone to irrational behaviour under these conditions as they enter and exit trades on a whim or in reaction to news stories and other reports in the press. The day traders and short term swing traders are both benefiting from and contributing to the volatility as they trade in and out of short term moves and patterns.

The chart below provides a clear picture of what is happening in the Australian equity markets. Volatility as measured in percentage terms is approaching levels not seen since the 1987 crash. In 1987 volatility reached just over 12%, today it is around the 10% level. By comparison, during the 1997 correction, volatility was approximately 5.5%, and even the massive sell off following the events of September 11, 2001 saw volatility levels of just over 4%.

A large number of traders are experiencing unprecedented levels of volatility, and really struggling to come to terms with what it all means for both their trading and investing activities. Many have only been involved in the markets through the relatively stable and low volatility period experienced during the bull market that began in 2003 and lasted until late 2007, and as a result, are confused and dazed by the current market volatility. Like a ‘deer in the headlights’ they are stunned by this sudden intrusion, and totally bamboozled as to what to do next.

The good news is that the volatility will eventually ‘wash out’ and return to normal levels at some stage. The unknown of course, is when? Following the 1987 crash, volatility took around 8 months to return to pre-crash levels. The fall in share prices then was however much sharper than the current crash. That crash happened over 2 days; this crash has so far taken several months to unfold.

The most important thing to do when trading during volatile times is to not only stick 100% to your trading rules, but to also ensure that your trading plan has a method of reducing your exposure to the market. It’s this lightened exposure that will reduce drawdown in a portfolio and keep the investor ahead of the bench mark.
Mechanical investors have detailed trading plans that consist of market risk evaluation -either LOW or HIGH, money and risk management rules, and strict entry and exit signals for individual trades. It’s the rigor and rules that mechanical investors build out of the market that enable them to execute the plan IN the market.

It is also vitally important to know well before hand what you will do when the volatility does return to normal, lower levels, which it will do. The prepared traders with a trading plan will know well in advance how and when they will re-engage the market and will act with certainty and confidence when the time comes. The unprepared will flop around nervous and uncertain as they wait for more and more ‘evidence’ to support their view, only to miss some great trades and add further to their own confusion.

Mechanical investors will know when the market returns to LOW risk, and will then be able to re-enter the market based on this overall market indicator. The individual trade signals will appear and will be given a position size based on the current risk of the market.

We don’t know for sure when this will occur, but when it does we will be able to re-engage the market with a much higher level of confidence than those traders who are unaware of the impact of volatility, and who are jumping in and out of trades with no real trading plan. An appreciation of volatility and the impact it has both on markets in general, and to the results of individual traders is vital to your long term success as a trader and investor.

The vast majority of equity investors tend to focus on developing their skills in individual stock selection, which is a difficult and time consuming endeavour. Not only that, but it is also an extremely difficult and inefficient way to increase wealth. Whilst we have all heard the stories of the “bloke next door who made a fortune buying XYZ stock at 40 cents and sold it at $10.00”, the reality is these situations are few and far between. They often occur as much as a result of luck as of any specific trading strategy, or because they happen to be privy to some market information which may not be known to the vast majority of market participants.

Two of the main reasons that most active investors fail in their endeavours to grow their capital through a ‘stock picking mentality’ are:

1. Placing too much emphasis on individual trades and
2. Not persisting with strategies that they start using.

Because investors have difficulty persisting with, or rather, remaining consistent in their execution of particular strategies, they are not successful in the markets over sustained periods of time. “I tried that once and it didn’t work!” or “It worked for a while!” are their claims to anyone prepared to listen to their negative anecdotes.

Part of the reason that they do not persist and the main reason that they fail with active investing is their inability to raise their thinking threshold to investing at the portfolio level. They operate at the ‘stock picking’ level, putting all their energy and time into trying to pick a winner or more appropriately, trying NOT to pick a loser!

Successful active investors raise their level of thinking to the ‘big picture’ level, that is, the portfolio level. Practically this is done by focusing on the overall equity curve rather than individual trades. The outcome of individual trades is of no concern to the successful active investor who objectively defines entry and exit points to individual trades regardless of whether the previous individual trades were winners or losers. They have this mindset because they know and fully accept, as a part of who they are, where profit and loss trades fit into their overall big picture trading approach.

They focus on the outcome of the combination of trades over a large sample over a long period of time. This is their edge in the market. The larger the sample, the higher the statistical reliability is of achieving the outcome of a researched edge. The equity curve that results from the large sample of trades is what is of utmost importance to the consistently successful active investor.

Developing a mindset that allows you to focus on the overall performance of your trading strategy over a long period of time requires a significant change in thinking for the majority of traders and investors. The results of individual trades need to be seen in the context of overall portfolio performance over a large trade sample. In the long run, the results of individual trades will be long forgotten as the equity curve of the trading system increases in value.

By placing less emphasis on individual stock selection and concentrating instead on the selection of a robust trading system, the investor comes to realise that no system will always work across all market conditions all the time. What becomes more relevant is the need to develop a mindset of acceptance of this fact. And an understanding that a system with a defined and consistent ‘edge’ in the market will be far more profitable over the long term than the majority of attempts to “pick’ stocks on an individual basis. Trading systems that have a positive win:loss ratio coupled with a positive expectancy will always outperform the overall market over the long term.

Those investors that have developed this mindset also know and accept that the system will have times when it is out of sync with the market. In SPA3's case, money management rules reduce a portfolio's exposure by taking investors into cash. New entry points become somewhat limited due to the SPA3 criteria not being met in the medium term. During this time it is important to remain focused and not be dragged into the negativity that will begin creeping into the financial press and the psyche of the vast, uneducated and unprepared majority of so called investors.

So, my question to you is “Are you concerned about the outcome of each individual trade, or do you trade with a set of well defined unambiguous rules that you trust will deliver an equity curve that will handsomely outperform the market index regardless of the outcome of individual trades?”

This week, for something a little different, I have provided a link to a Podcast I did with Louise Bedford.

In this Podcast Louise and I discuss the benefits of using a mechanical system for trading the markets. In it, we discuss how a mechanical trading system can give you a clear edge to become a profitable trader instead of just an ‘also ran’ like the majority of traders - Particularly those using discretionary methods in their attempts to be profitable. Coupled with this, I explain the use of a mechanical trading system or methodology to give you a mathematical edge to outperform the overall market index, and how a full understanding of positive expectancy, win:loss ratios, position sizing and money management will allow you to trade with consistency and thus profit from your trading activities.

I also explain the difference between a ‘black box’ trading system, and the open and transparent nature of the SPA3 trading system. Unlike a typical commercially available ‘black box’ system where the entry and exit formulas are protected by the system developer, SPA3 signals are available for everyone to read and understand.

Louise discusses her trading journey and how the shift to mechanical trading allowed her to become consistently profitable after many years of hard work and inconsistent results when using a discretionary approach. Louise encourages listeners to employ the use of a repeatable system with consistent performance results, and to follow the rules of the system, if they wish to be truly successful and profitable traders.

Also available with the podcast is a free Discovery Session DVD that was recorded in August 2008. The DVD explains in more detail SPA's mathematical edge. If you haven't yet viewed the DVD, click the link on the right to register for your copy.

I hope you enjoy the podcast which can be accessed by clicking on the link below.

As always, I welcome your comments and feed-back, and trust you gain further insight into the benefits of a mechanical approach to engaging the markets from listening to the podcast.