Last week we started talking about a topic that, I argued, is too important to be ignored – risk-adjusted returns. This week we continue with this theme and look at why, now more than ever, you’ve got to be focused on the overall health of your portfolio.

There is a tremendous amount of uncertainty in the world at the moment. We are in uncharted waters everywhere we look. We’re seeing a breakdown of trust across the board.

People don’t trust their leaders. Countries don’t trust each other. Banks don’t trust their clients. Clients don’t trust their banks. Businesses don’t trust their governments and vice versa. I could go on and on.

Trust is the bedrock of a functional society. In such a toxic environment of mistrust, it doesn’t take much for things to very quickly spiral out of control. It’s true for society … and it’s true for financial markets.

More than anything it’s this absence of trust that has me worried about the current environment. We can’t keep heading down the road we’re on. It feels like something has to give. It’s a time to be prepared for a sudden and shocking storm … and hope that it never arrives. The good news is, it’s not that hard to prepare your portfolio for a possible storm.

No one has been more concerned about the possibility of a coming storm than investment analyst and publisher Porter Stansberry. For the past six months he has taken every possible opportunity to warn his readers in no uncertain terms that he believes a massive storm is headed straight for us.

In his flagship newsletter, Stansberry’s Investment Advisory (SIA), he has acted accordingly and has taken action to hedge his portfolio against the storm that he’s expecting any day now. He has been proactive about reducing the risk in his portfolio.

I’ll talk about some of his hedging methods a bit later but first I want to take a look at how his portfolio has performed during the expanded market volatility we’ve seen in the past 6 months.

Not surprisingly, Porter’s hedged SIA portfolio weathered the market downturns of the last six months very well. His short positions (which rise as the market falls) cushioned his returns during the recent market declines. Let’s take a look.

The following chart shows the performance of the SIA portfolio (using an equal-weighted index approach) over the last six months.

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In spite of the significant market volatility we’ve seen in the last 6 months, the hedged SIA portfolio has been surprisingly calm. It dipped just 1.7% below the zero line back in September 2015 and the peak to trough drawdown over the last 4 months was just 4% (from late December 2015 to early February 2016).

How did the S&P 500 do over the same period of time? Let’s take a look.

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Those are incredibly different results. The peak to trough swing in the S&P 500 was 3.5 times greater than the swing in the SIA portfolio. The maximum loss was nearly 5 times greater in the S&P 500.

To really drive the point home, let’s overlay the two results one on top of the other.

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As I mentioned last week, there are lots of different ways to calculate risk-adjusted returns, some of them very sophisticated. It doesn’t take a genius, however, to look at these two portfolios and know which one has produced the better risk adjusted returns. When your risk is lower AND your returns are higher, it’s case closed, no matter what your metric.

It’s still fun, however, to look at pictures … and if we use the same approach that we applied last week when we looked at the risk-adjusted returns of Microsoft and McDonald’s (dividing the gains of the equity by the volatility of the equity) we can see how dramatically the SIA portfolio has outperformed the S&P 500 on a risk-adjusted basis during the recent market volatility.

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That’s the kind of performance you should be looking for in your own portfolio. How can you achieve the same kind of risk-adjusted performance yourself?

When I study Porter’s SIA portfolio, I see several key ways that he has lowered risk without sacrificing return.

  • Most importantly, he has searched for and recommended stocks that tend to produce high risk-adjusted returns on an individual basis. These kind of stocks form the core of the SIA portfolio.
  • In sectors of the economy that he feels are the most vulnerable to tightening market conditions, he has been willing to sell the worst stocks short.
  • When he finds a stock that he likes but that is in a risky industry (such as energy or online retail) he hedges the industry risk away by using pair trades. Pair trades are when you go long the stock that you like in the industry and short a less promising stock from the same industry.
  • Finally, Porter has peppered his portfolio with a few recommendations that are uncorrelated to the rest of his portfolio (e.g., gold mining stocks).

Such strategies take a little work but are well within the reach of the individual investor, especially when using TradeStops.

It’s a good time to take a close look at your own portfolio and see where you might need to patch a hole or board up a window. If trust continues to break down in the markets, you’ll at least want to know that you can trust your own portfolio,

Richard_Signature
Richard M. Smith, PhD
CEO, TradeSmith
Founder, TradeStops.com