PP Assets Volatility Capture Trading

[Clive]

...

[stone]

Clive, lots of food for thought . I hope my questions aren't too much based on my misunderstanding. In principle could you make your scheme independent of when someone entered it? So someone entering now would pretend that they had started in 1972? If you were to do that, how much cash would have been held at various times? Would plenty of cash have been held for 1981 when cash out performed  LTT, stocks and gold? Why do you keep cash and ditch the LTT? It would be great to see the year by year table for your scheme for say the USA and Japan.

Does it boil down to you coming up with a "fair value of the SP500 in gold" such that based on the SP500 level and gold price you could advise what ratio of gold to stocks people should hold?  Are you saying that the cash and LTT components of the PP only act to reduce volatility and act as a comparative drag on long term gains? If so, then I don't see why anyone should ever be in cash. This then comes back to the Japanese example. Would your scheme have been less good in Japan? Am I right in thinking that they would have held some gold and no stocks at the time of the 1990 crash and so would have been OK then? How would the lack of LTT have affected your schemes Japanese performance? What would the Japanese 1972 started portfolio have looked like over the last couple of years?

I have wondered whether the PP could be started now assuming one was joining a 15%-35% rebalanced portfolio started in 1972. So the ratio would currently be somewhat off the 4x25% mark. For me lack of volatility is very important because our PP is "for contingencies" ie for when we can't time selling it off. I hoped that keeping tight to 4x25% would keep volatility down.

[stone]

Clive could it be made predictive by factoring in the Tobin Q ratio of the replacement cost versus market cap of the stock market, inflation adjusted dividend yields, inflation adjusted interest rates and the extraction cost of gold versus its selling price? Perhaps doing so would give out a recommended ratio of stocks:gold:cash:LTT. Perhaps it would alsways give out 4x25% .

[stone]

Clive, I'm actually wondering whether such an "optimal surface" of ratios of cash, gold, stocks and LTT as based on what historically would have given the best subsequent 1 year returns given the real interest rate, stock Q ratio and real dividend yield and gold price/production cost ratio might throw up some red flags about gross mispricing events. Perhaps it would at critical moments diverge greatly from the 4x25%. Its the kind of thing for a variable portfolio I guess.

[stone]

Clive, I just saw your most recent reply. I agree that predictions are possibly bound to be rubbish. I'm interested by your estimation that the PP will give a -50% crash. Perhaps it is just as well that my better half insists that we are so over weight in cash. Its a diversity of styles as you recommend. Her style being 100% cash. In fact her style without my influence would probably be 100% cash in a current account that paid no interest .

[stone]

Clive, am I right in thinking that so far, across those different countries, the PP has yet to have such a calamitous alignment? I also worry that without gold, inflation could bite. I thought Gumby's inflation adjusted PP and SP500 chart showed the real point of the PP. To my mind, your stop loss method seems based around the prediction that a loss now is predictive of a further subsequent loss. To my mind "money management" is about avoiding a 100% loss (such as from leverage or short selling). Clearly zero multiplied by anything is still zero and so a stop loss is needed for such situations. If there is no chance of getting a zero, then it just boils down to whether a loss up until now is predictive of a further loss??? I'm not saying that it isn't. I'm just saying that such a prediction seems implicit in that strategy.

[stone]

Clive, did gold get stopped out in Iceland in 2008? Also could you rely on stopping at -10%. If you had tried to stop silver at -10% last spring, you would have ended up stopping at -30% (as the fall was effectively instant). Silver has rebounded a bit and this year might have silver outperform pretty much everything. I'm not saying silver is a sensible thing to hold, I'm just saying it might be an example of how all assets behave in a dystopian (near?) future.

[stone]

Clive, I just saw that ILSC are no longer on issue (since yesterday). I bought in on the latest issue and my better half agreed to put an allocation in in her name too over the coming months. Without  ILSC, cash will be lagging inflation by a couple of percent at least. It might turn out to be much much more I suppose.
What I don't know is how gold in 1981 compared to now in terms of other drivers of its cost. Affordability for Indian Jewelery is one big factor. If Indians use 8tonnes per year now, it is possible that if the price drops 20%, they will use 12 tonnes and so moderate any price fall. Perhaps as Indians get richer relative to us they will buy much much more or perhaps they will respond to affluence by no longer liking gold jewelery- buying stainless steel Swiss watches (or plastic Chinese ones like me) instead??? Also am I right in thinking that gold miners are missing production targets. Perhaps the extraction cost will climb so that it keeps price with the selling cost. I agree gold could easily tank. I have already made a premature rebalance out of gold back to 25% gold. I just find currency and stocks also leave a lot of room for doubt.
I guess I have lower expectations than you. I only aspire to average out zero real returns long term. My hope is that a PP loss will get made up for subsequently. I see the PP as a way to minimize inflation adjusted volatility, not as a way to get real gains. I'm not striving for long term real gains.

[stone]

Clive, don't you agree that if you were playing dice, then a stop loss would never be able to reduce your risk if you ever intended to come back to the game? You would have just the same chance of hitting a run of 6s and loosing everything if you had stopped after a few consecutive 6s and come back to the game 20years later than if you played the whole game at once. The only way a stop loss would help would be if you learned your lesson and never played again. That is why I'm saying that the annual stop loss is a predictive strategy. You are basing your strategy on the belief that the remaining months of this year are worse for whatever you have stopped out than next year will be. That predictive strategy may well be valid. I guess your back test shows that it is valid.

[stone]

Clive, just to clarify, are we talking about a hypothetical "coin flip Dow" or a real stockmarket? I can understand how strategies you describe might work in a real stockmarket but only in so far as a real stockmarket deviates from a "coin flip Dow" (ie some simple game of chance such as flipping a load of coins). No betting sequence such as a Martingale or D'Alembert or anything else can alter the rules of chance. All it does is to shift a lot of small losses into being occassional bigger losses. If there were a million people playing a game of chance using a Martingale strategy then, in aggregate, they would do no better or worse than would a million people playing the same game of chance with no strategy. http://en.wikipedia.org/wiki/Martingale ... ty_theory)

Buying lots of Dow 3000 but not lots of Dow 12000 only makes sense if one takes a value approach ie if one is dealing with a real stockmarket not a coin flip Dow. In a coin flip Dow, the chance of a 10% rise from Dow 12000 is no different from that from Dow 3000. Your strategy then just decends into being a betting sequence.

A Martingale betting sequence with a "coin flip Dow" might make sense if you borrowed £1T to conduct it and so got classed as a too big to fail financial institution with all the government bail out privaledges that entails. That is a time honoured strategy by our "wealth creators" .

The other instance when such a betting sequence might make sense is if you have an emotional preference for having a slim chance of a huge loss rather than having a less slim chance of a smaller loss. If we agree that a million people in aggregate would get the same result either way, then it becomes a matter of personal emotion. For me, I'd rather have a greater chance of a smaller loss and so would strenously avoid any betting sequence. In a game of chance, a random approach is the optimal "efficient frontier" in terms of not concentrating losses. By stringing your stop loss trades out to one a year, you are simply playing a dangerous game of chance in slow motion. I have to stress that personally I think you are saved by the fact that (unwittingly?) you are  making sound predictions about real stockmarket price momentum and value (ie a 10% fall is predictive of a further fall in the coming months, Dow 12000 is more likely to fall than Dow 3000 etc etc). If you really were dealing with a coin flip Dow, then sooner or later, you would have a long sequence of getting stopped out on consecutive trades- loosing 10% each time until you were broke.

[stone]

Clive, I'm still failing to follow the logic. You are not arguing that a million people following your scheme would beat a million people just with the cash:stock ratio and no scheme are you? Wouldn't a series of -10% stop outs result in you having too little money left for it to be worth putting a trade on? We are dealing with unlikely events. You are claiming to be able to be safer than having the same cash:stock ratio permenantly invested would be. Your basis is the doomsday scenario of successive large losses. I'm just saying that all you have done is to obscure but not alter the rules of chance and you are just as likely to get stuffed by a series of stop outs.

[stone]

Clive, do any of your methods guard against, each year putting your money in, loosing 10%; next year also loosing 10%; next year loosing 10% etc etc. That is the way I envisage the large cumulative loss coming about. It does not entail Dow 0. It simply entails unlucky early stop outs perhaps followed by a subsequent recovery that you miss. I don't think that that is even very unlikely. We could be going into a period of heightened volatility such that a much greater proportion of years get stopped out. Perhaps both for stocks and for gold.
Look a 2xsilver ETFs or gold mine shares as an example of hightened volatility. Even though those have strong growth as a trend they are very likely to get stopped out even in a good year. The Martingale effect will probably make the stop loss strategy appear beneficial initially but then you will hit a long sequence of stop outs just by chance.

[stone]

Clive with the "coin flip market model" you could actually calculate how your chance of getting successively stopped out related to the level of market volatility.

Lets be explicit about the "coin flip market model". It can be set at volatility levels ranging from "tranquil" to "blood on the streets".
In "tranquil" mode, each day a coin is flipped and if it is heads, stocks increase by 0.11% and gold falls by 0.1%. If it is tails, stocks decrease by 0.1% and gold increases by 0.11%.
In "blood on the streets" mode, heads means stocks increase by 11.12% and gold falls by 10%. Tails means stocks decrease by 10% and gold increases by 11.12%.

You can see that in tranquil mode you will seldom get stopped out either for gold or for stocks. In blood on the streets mode you will essentially always get stopped out for both. The risk of a succession of double stop outs increases with increasing market volatility in an extremely non-linear way. Once volatility gets to a certain point, you effectively hit a wall of certain calamity.

Be careful about applying the concept  that you are only staking the interest gains from a cash pool. That argument could be used to justify buying lottery scratch cards as an investment strategy .

[stone]

Clive, I totally concure with everything you say about the value of rebalancing. It is simply the stop loss part of your tool kit that I wouldn't touch with a barge pole. The buying more stocks when the price is low idea seems very sensible for a real market where value counts. Obviously a "coin flip market model" has no sense of value and no mean reversion and so that strategy wouldn't work for such a hypothetical coin flip set up. If someone asks you to choose heads or tails, you don't care what the last ten flips came out as. I think you are more of a value investor than you acknowledge.
Did gold really have low volatility in the lean years from 1980-1999? I thought it was a volatile bear market

[stone]

Clive, just eyeballing those orange prices makes it clear that they are not following a coin flip model but instead are jittering around a trend line. Compare the look of your orange chart versus examples of coin flip model type charts eg:
http://en.wikipedia.org/wiki/Random_walk
With that level of short term orange price volatility, a coin flip model would give much much bigger overal moves IMO.

I had the impression that the bread and butter work of financial quantative analysts was identifying the underlying trend lines through the fog of jitteryness ie searching for the non-randomness. I'm totally ignorant of what finance people do but I do know that Brownian motion experts get employed by the finance industry. I guess they aim to harvest the jitteryness whilst avoiding getting impaled by any trend line.

[stone]

Clive, percentage wise aren't those sizable moves? The chart makes the $300 zone look smooth only because it is scaled to include the $1500 zone so $10 moves from $300 don't show as much as $50 moves from $1500. Am I totally misreading this? 

[stone]

Clive "Very generally SL10 (10% stop loss) will stop out on average in 50% of cases"

My problem with it is that it stops out when volatility is high and doesn't when it doesn't. The effect of volatility is very dramatic. As volatility rises, SL10 suddenly will get stopped out essentially every year. You will then just be throwing away 10% every year.

[stone]

Clive, first off, best of luck with what ever you do and please don't let it get to you that I don't "get it". I'm one of those people who always has an opinion about anything and my opinions generally aren't shared by a single other person so presumably are nonsense .

Anyway, as I see it:-
You came up with 10% as a value for your stop loss because you had experience of historical volatility. Your supposition is that in the future volatility will be like it has been in the past.

In order to see my point about how much you have resting on that supposition, tighten down the stop loss limit to 5%, 3%, 1% and see how things suddenly fall off a cliff with getting stopped out every year. You have fine tuned the stop loss so as to give approx 50% exposure based on historical data, but an all too likely shift in market dynamics would convert that to a certain 10% annual loss. Lately both gold and stocks have become very volatile. The price of gold may be negatively correlated to the price of stocks but volatility of gold certainly is not negatively correlated to volatility of stocks.

Anyway, even if you are lucky and volatility in the future is much like it was in the past, what do you have to gain? To my mind there are two ways to explain the good historical results. One way is to say that the stop loss success is based on momentum trading- ie that a 10% loss is predictive of a subsequent further loss in the coming months. If that is true (and it could be investigated if someone wanted too); then the "relative strength" approach would be a preferable way to capture that IMO because it is not subject to the particular risks of the SL10 approach I'm on about. The alternative is that the apparent SL10 success is just an artifact of the "betting sequence" characteristic in built in the strategy. If so, then you are just swapping steady modest gains for better gains interspersed with rare sequences of repeated stop outs that wipe out those gains. You will never know when such sequences will occur. That "betting sequence"  risk is over and above any extra risk of having misjudged volatility.

[stone]

Clive "From that lower (stopped) price level, generally there's 50-50 chance of either the price continuing down or rising."

Depending on the relative amounts, that makes it sound like we have a betting sequence scenario rather than a momentum trading scenario. You seem relaxed about following a betting sequence and seem to consider that drawing it out over several years makes it "safe".  When you talk about an "efficient frontier" stop loss setting what you are really meaning is not that you have somehow dodged the immutable laws of chance but that you have maximised the redistribution of your losses into sequences of successively being stopped out rather than just being (smaller) all at once losses. Don't you agree that if you had a random walk market model and re-ran it again and again, then your  "efficient frontier" stop loss setting would never be able to over time beat a rebalanced stock:cash mix? If we disagree on that then I guess either I'm in a muddle or you don't believe the laws of chance.
http://en.wikipedia.org/wiki/Martingale ... ty_theory)

[stone]

Clive, I'm still left thinking that you have simply devised a very convoluted way to slowly swindle yourself. The key point is that it is yourself. It is none of my buisiness and I genuinely hope I'm wrong.

[stone]

Clive, my impression was that what your annual stop loss method ends up doing is letting the winning streaks play out "in real time" whilst drawing out time for the loosing streaks. So rather than someone having a -35% down year, they have four consecutive  -10% down years. Does that count as an advantage? There is also the Sword of Damocles hanging over it in the form of the possibility that volatility will change long term so as to cause a certain 10% loss every year from now on. Like I said, best of luck with it but I'm spooked.