Dialing in your Risk Level through Leverage

[melveyr]

I have been doing a lot of reflection on the PP lately, trying to find out what truly drives the portfolio. I have recently been exploring the PP's use of duration as a form of leverage which you can read about in this thread:
http://gyroscopicinvesting.com/forum/ht ... ic.php?t=6

Once I became comfortable with the idea, I realized that the amount leverage is a unique risk factor that is separable from the underlying strategy. The interesting thing about leverage is that you can quite easily fine tune the amount of risk you want. If you have a great strategy with a high sharpe ratio but a lower CAGR than you would like you can simply lever it up. Similarly if you have a strategy with a high Sharpe ratio but too much risk, you can use cash to delever the portfolio.

Combining my previous thoughts about duration as a form of leverage and customizing risk tolerance through leverage, I think I have a good framework for customizing the PP's risk level.

Let's start by looking at the most levered PP:
25% ZROZ
40% GLD
35% VTI

At first glance it might appear that this PP has less deflation protection because it has less bonds, but this isn't so. What I did was look at 2011 volatility for each instrument, and this mix gets the weighted volatilities equivalent to each other. This also explains why the gold and equities don't have equal dollar amounts; gold was the least volatile of these instruments in 2011.

We can delever this PP by moving towards lower duration bonds:
35% TLT
35% GLD
30% VTI

Delevering even more:
48% TLH
27% GLD
25% VTI

More:
57% IEF
23% GLD
20% VTI

More:
73% IEI
14% GLD
13% VTI

You can see the results on the following graph (higher numbers indicate more leverage):


A final separate point is that doing volatility based weighting will probably be more robust in the long run because it can adjust to structural changes . In the late 70s gold price volatility climbed dramatically meaning that the portfolios performance became dominated by gold. In my backtests the PP suffered a 30% drawdown when the gold bubble popped; this could have been mitigated by simply weighting based off of backward looking volatility. Currently the volatilites of TLT, VTI, and GLD are similar so we probably don't think about it too much... but its something to keep an eye on.

[D1984]

A final separate point is that doing volatility based weighting will probably be more robust in the long run because it can adjust to structural changes . In the late 70s gold price volatility climbed dramatically meaning that the portfolios performance became dominated by gold. In my backtests the PP suffered a 30% drawdown when the gold bubble popped; this could have been mitigated by simply weighting based off of backward looking volatility. Currently the volatilites of TLT, VTI, and GLD are similar so we probably don't think about it too much... but its something to keep an eye on.

I'm just curious...do you adjust weighting at the end of each year based on the previous year's performance (i.e. the more volatile the asset was over the past twelve months the less of it you would hold over the next year)? How much gold would you have been holding in 1973, 1974, and 1979 under this method of PP weighting?

[k9]

Mortgages is a variable you can use too to deal with leverage. Investing rather than paying back your mortgage is the same as using leverage. If you want less leverage, you can pay back a part of your mortgage. If you want more leverage, reduce the payments to the minimum possible value.