I’ve written about the relative strength system for investment selection in the past. This is based on an updated Ivy Portfolio by Mebane Faber. He made a number of suggestions in his original academic paper and his book. One of these was the relative strength methodology for selecting assets, and another was to choose the top x (whether this is 3, 5, 10, or some other number) of the best performing assets. This is where my research has taken me.
As described previously, my investment policy was to own a diversified set of 20 assets, all with a 5% weighting in my portfolio from 1o different asset classes. This was weighted so that the best performing asset classes were over-weighted (with a total of 3 holding for 15% vs. 10% for an average) and the 3 worst performing asset classes were under-weighted and only held a single holding (for 5% versus 10% on average). The remaining held the average weighting. This was a very diversified portfolio, always holding an asset as long as it was above the moving average signal. The purpose of this portfolio is to be very safe, and limit draw-downs. Upside returns were sacrificed in order to achieve further safety. This will still be a significant portion of our total stock holdings.
The primary change to the methodology, is to only hold assets in the top 3 asset categories. This is represented as the highlighted areas above. Instead of holding 5% for each holding in the yellow above, this portfolio goes all out and allocates 11% to each of the 9 top holdings.
The Updated Investment Rules:
- Own the asset class if price > 20 or 40 week SMA
- Sell the asset class if prices < 20 or 40 week SMA
- An asset class will be owned at 11% of the portfolio, if owned
- For every asset class on a sell, the worst performing assets may be shorted to a maximum of 20% of the portfolio
- Only one signal or trade of asset per week.
- Sell on the week of the signal, buy on the end of month signal.
The Top-3 portfolio will be the other half of my holdings. This one is designed to take additional risk, and with it I expect to achieve higher returns over time.
Back-testing this methodology with the same set of portfolio holdings as the original methodology produces excellent long term results. Examples of the holdings in the various asset classes are shown below. Additionally, the long term results of the system broken down for the last 10 years have been very good, and while there are years where it under-performs the index and at times does lose money, overall it is fantastic system.
You can see that the results of system over the span of more than 700 trades results in a win percentage of 69% and a fairly low correlation with the S&P 500. This results in a compound annual growth rate (CAGR) of greater than 20%. In real life conditions, I’ll be quite happy with even 15%. Some warnings, though. This is a best-guess back test, not an exact testing of the methodology due to the constraints of the testing platform here.
I’ll be providing updates to the portfolio monthly, as well as return results compared to the S&P.
Readers, what do you do for your investments? Do you have an investment policy that is written down? How do you manage risk with your investments?