Thursday, March 12, 2009

Concept

What is an adaptive investing system?

Looking at the historical investment data, we know that the period between 1982 and 2000 was the bull market, the best strategy is to buy and hold. We know also that the period between 1968 and 1981 was bearish market, the buy and hold strategy doesn’t work, while trading may work very well. In addition, there is bear markets for a short period of time during big bull marke cycle. It is clear that a simple fixed methodology doesn’t work as the market constantly changes. In other word, all different solutions, such as buy and hold, trading, active, passive, asset allocation and trend floower, can work only for a specific period of time. Therefor, the the best way is to change your investment strategy to match the market condition. From mathematical point of view, we need to develop an investment system that is adaptive by configuring a few parameters based on market condition.

Background

Adaptive investing is NOT new, which can be found in Internet. However, the idea here is definitely different from the current existing adaptive investing strategy. The existing idea is to allocate different asset classes based on market condition, which is similar to the tactical asset allocation. The adaptive investing here is to buy or sell the same asset class (or type) with different prices based on market condition. This allocation can be defined as price allocation. Most of current investment strategies are based on asset allocation, while the adoptive investing is based on price allocation. Asset allocation can be considered as horizontal allocation, while price allocation can be considered as vertical allocation. For example, using asset allocation, you can hold 25% Canadian equity, 25% US equity and 50% bond. On the other hand, using asset allocation, I’ll buy only gold sector, with 10% buy at price of 15, 20% at price 10, 40$ at price of 5 and so on. Similar to the buy process, I’ll sell it 10% at process of 20, 20% at price of 30, 40% at price of 50 and so on.

The second major difference is that the adaptive investing only buy or sells ETFs, not individual stocks. ETF can be any kinds of ETFs, including Canadian equity ETF XIU, energy sector ETF XEG, Oil commodity ETF USO, and leveraged gold ETF HGU. the reason of not trading individual stock is that individual stock can be ZERO, while ETF can never be ZERO.

Problems to be resolved by the system

Hunting for extreme (H4E) have two issues to be resolved. If the market is not in a extreme situation, in fact, most of time, market is not in a extreme situation, what to do to get profit. Based on H4E, we should not do anything at all; instead, we should wait for extreme and then act upon the situation. However, if you trade the market within a range, then you can make profit as well. One thing in the market is for sure, which is constantly changing, if there is change, then there is money to be made.

As known, even in the extreme situation, market won’t go one way for a long period of time. Market is always with big fluctuations during any primary trend, whether it is bull or bear market. It could be very big emotional challenge when you see your profit lost again and again. We all know that the price doesn’t go lower forever. Regardless of how bearish it is, it always has bounce back for a while, and then go lower again. Why don’t we sell part of position and then buy it back when the price goes lower than sold price with a give amount. This is a good idea to rebalance your emotion and to reduce the pressure as well, which could bring much better return, including this intermediate return from buy and sell, and the final return. The reason being is that you’re not under pressure, as you don't watch your profit coming and going. When price is high, you’re happy as you sell a percentage and take some profit; when price going lower, you buy it back and you’re happy as you see your realized profit. When price goes even lower than your next price target, you’re happy, as you’d like to collect more shares. It is obviously that market changes constantly, whether it is based on collective emotion, fundamental, technical or seasonality. The task of the adaptive investing system is to capture the profit; furthermore, such a system can provide a way to reduce your pressure and emotion challenge.

Input parameters to the system

There are only two parameters: an investment ETF and its market environment. For example, I am very bullish for gold sector. There are more than 1000 ETFs existing in the world. You need to choose a few ETFs to be included in the system, the only criteria is to have a clear judgement of their market environment. It is not necessary to be bullish. 5 market environments are classified as below:
1) Very bullish: described in H4E as extreme
2) Somewhat bullish
3) Sideways
4) Somewhat bearish
5) Very bearish: described in H4E as extreme

Please note that market environment refers to an ETF, not the market in general. For example, when general stock market was bearish from 1968 to 1980, the commodity market was very bullish. When general market, such as DOW right now (march 2009) is bearish, gold is bullish, and oil is bearish.

How to judge market condition is based on your understanding and knowledge of two areas:
Financial history: It is the best defence weapon. The more stories you know, the more comfortable you’ll be. I believe that stock market behaviour never changes, as human being with fear and greed drives market.

Psychology: emotion and sentiment play very important role to determine market price.

How the system works

You can see the detail in the system chapter. Below are the high level pictures:

very bullish
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somewhat bullish

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Sideways

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