Here’s a chart of long-term asset performance….
- The blue line shows returns from US stocks from 1900 to today. That’s a 48,000x increase in nominal value.
- The yellow line shows the returns from US bonds from 1900 to today. That’s a 300x increase in nominal value.
If you look at this in isolation things look easy. You just buy all this stuff.
And it is both that easy and not quite that easy…
We need to ask: Why does this stuff go up? Can we be confident it’s going to go up in the future?
This post is a lesson taken directly from Zero to Robot Master Bootcamp. In this Bootcamp, we teach traders how to research, build and trade a portfolio of 3 strategies including a Risk Premia Strategy, an Intraday FX Strategy and a Volatility Basis Strategy. If you’re interested in adding strategies to your portfolio or are just keen to start on the path to becoming a successful and sustainable systematic trader, you can check out full details of the Bootcamp here.
For more on Risk Premia Harvesting, including an examination of the risk factors behind risk premia, check out this post.
Well, take another peek at the chart above. Notice the logarithmic y-axis. That’s the best way to look at long term asset prices, but it doesn’t give a very good idea of what it would actually have felt like to be long that stuff.
Now, look at this, which takes the blip in the red square, corresponding to the Global Financial Crisis in 2008/9 and plots the S&P500 stock index in dollar terms.
That 50% decline looks benign in the long-term chart – but how would you feel if your million-dollar stock portfolio was suddenly worth $500k?
Doesn’t sound fun, right?
The reason that stocks tend to go up in the long term is that they tend to go down (sometimes violently) in the short and medium term.
This doesn’t just apply to stocks. Any asset whose fundamental value is dependent on particular uncertain factors (or risks) tends to increase more over the long term than the interest you would receive on the same money.
So we don’t say investors are compensated for investing in assets, we say that investors are compensated for taking on risk. Hence the concept of a “risk premium”.
We only get paid over the long run for taking on risks that others find distasteful.
The reward is the premium for taking the risk and we can’t divorce those effects. If we make the risk go away, the premium goes away too.
Our main lesson here is very simple.
- As investors, we are rewarded for taking on certain long term risks, which include buying assets that are sensitive to disappointment in economic growth, inflation and interest rates.
- So we want to get long exposure to these assets. And getting long lots of them dramatically reduces portfolio volatility through diversification.
- So a strategy that buys stocks, bonds and other risk assets is smart if your return horizon is long.
As always 80% of success is showing up. So the precise way you buy and manage risk assets matters a lot less than the fact that you do it at all.
But we’re going to put our best foot forward to put together a simple but effective Risk Premia Harvesting strategy together that manages risk in an active way.
So let’s talk simply and systematically about what we’re trying to achieve….
We’re going to ask and answer the following 4 questions…
- What effect(s) are we harnessing?
- Do we have clear evidence of these effects?
- Do we have a strong reason to think these effects will persist?
- Can we robustly harness these effects in a trading strategy?
What effects are we trying to harness?
Well, there are two…
By far the most important is to harness risk premia effects (or positive drift) in risk assets. We’re looking to get long and stay long these risk assets, and collect the long term risk premium. Which is a fancy way of saying we want to be long these assets because they go up.
Second, and less important, we noticed that volatility trends and that we can use that to smooth out the volatility of risk assets. This also appears to increase risk-adjusted performance as a side effect – but we’d want to do it even if it didn’t because it makes our exposures easier to manage and reason about.
Do we have clear evidence of these effects?
Yes – an absolute ton. These are the two effects we can feel most certain about in the whole of trading… which is why we are looking at them first.
If we can’t feel confident about these two effects, then we’re not going to feel confident about anything in trading.
Do we have a strong reason to think these effects will persist?
Yes – I think so.
- There’s a very good economic and behavioural rationale for the continued existence of risk premia effects.
- Risk premia harvesting is win-win. I’m happy to take on risk others don’t want to get the rewards, and others are happy to not take it on. It’s sustainable in that way, and unlikely to be competed away.
- Finally, there’s a ton of empirical evidence of both effects being persistent across time and all kinds of financial assets.
Can we robustly harness these effects in a trading strategy?
Well, I think so, obviously. But we have some questions to answer, some self-imposed constraints we’re under, and some trade-offs to weigh up.
We’re going to try to put together a strategy which is tradeable in a small, non-margin account. So it’s going to trade a small number of ETF assets from the long side only, and we’ll need to be mindful that frequent small rebalance trades are not always cost-effective on a small account.
We also want something that trades infrequently enough that it can be traded by hand. At least to start with…
Let’s get on with it… What assets are we going to trade…?