, Investing Strategies

The Single Most Powerful Technique I Know

July 7, 2015 / by TradeSmith Research Team

I recently came across a critically acclaimed financial book published by Wiley and written by a highly regarded (and highly credentialed) Beverly Hills financial advisor. The book is Balanced Asset Allocation, by Alex Shahidi. I learned about it in a recently published article in the journal of the American Association of Individual Investors.

What’s the big cutting-edge idea in this book that everyone is getting so excited about? Adjusting asset allocation for the volatility of the asset classes.

I’ve been shouting from the rooftops about this same idea for over a year now with my volatility-based position sizing! I’m glad that the rest of the financial industry is finally catching up.

Seriously… it’s important to me that you understand the value that you’re getting from TradeStops. Not only do we educate you about cutting-edge financial ideas (usually before everyone else does), we also give you the tools to actually use the ideas.

It’s amazing to see all of the books being published now on things that I’ve been talking about for years. In addition to Mr. Shahidi’s new book, there’s The Behavior Gap by Carl Richards, What Investors Really Want by Meir Statman and Misbehaving by Richard Thaler.

These are all great books that I would highly recommend. What’s astonishing to me, however, is that so many talented people (and publishers) can articulate the problems but so few actually offer practical solutions for individual investors.

TradeStops offers solutions. In fact, we’ve been articulating the challenges of investing AND offering easy to use solutions for over ten years now.

In the spirit of solving investor challenges, let’s take another look at how TradeStops helps investors allocate for volatility.

In TradeStops we call this process VQ Position Sizing. The concept is simple. Here’s how it works.

Decide on a dollar amount that you are willing and able to risk on each position in your portfolio.
Get the current Volatility Quotient (VQ%) for each equity investment in your portfolio.
Divide the amount of money you’re able to risk by the current VQ% to get the amount of money to invest in each position.
Buy as many shares of each position as this amount of money allows.

I put together the following sample portfolio of 20 stocks by scanning the morning financial media sites. I just took the first 20 tickers that I came across.

If we assume that we have $100,000 to invest in these 20 stocks then one approach would be to allocate $5,000 to each investment. That’s what I’ve done in the two “Eq Value” columns below. These two columns represent what I call the “Equal Value” approach to investing. In other words, “I’ll just put an equal amount of money into each investment.”

The last two columns in this table represent what I call the “Equal Risk” approach to investing. Instead of putting an equal amount of money into each position we take an equal amount of risk on each position. In the case of this particular portfolio, we were able to allocate $860 of risk on each position (and still stay under our $100,000 portfolio size). We then took this risk allocation and divided it by the VQ% for each investment to find out how much money we could put in each stock.

I’ve color coded the last two columns so you can easily see for which investments we reduced the amount of money invested and for which positions we increased the amount of money invested.

Our biggest reduction was in Tesla where we reduced our investment size from just under $5,000 to just under $2,000. That was a reduction of nearly 60%.

On the other hand, our biggest increase in investment size was in Wal-Mart where we raised our investment from $5,000 to nearly $8,000 – an increase of about 60%.

Let me share with you another way of looking at the above reallocation.

These charts are based upon the portfolio VQ Analyzer in TradeStops Pro. Here we’re looking at a donut chart showing how much of our money we have allocated to Low Risk (blue), Medium Risk (green) and High Risk (orange) investments.

We can easily see that by changing our investment sizes from being equal value based to being equal risk based, we have moved more of our money out of high risk and medium risk investments and into low risk investments. This is exactly what it’s supposed to do. Moreover, we’ve also reduced the overall risk of the portfolio from 12.2% down to 10.7%.

That’s what I call low-hanging fruit for improving your investing. It has literally nothing to do with what stocks you decide to buy. It has nothing to do with when you buy or when you sell but it will almost certainly improve your investment returns.

How do I know that? Because I’ve seen it happen over and over again. More than any other single strategy that I’ve developed over my decades of research, this equal risk investment allocation strategy produces the most consistent improvement in performance.

I recently concluded, for example, an exhaustive study of 10 portfolios of individual investors – investors just like you and me – and I found that implementing just this one simple strategy improved the overall returns for 7 out of the 10 these investors. Moreover, the average improvement across all 10 investors was an astonishing 26.5%.

That’s an astonishing result for such a simple and stress-free adjustment to your investing.

Let me show you a couple of examples of how investment returns were increased by this simple strategy.