Relative strength portfolio - top 3 asset classes 10 year return

Relative strength portfolio - top 3 asset classes 10 year return

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.

Asset allocations - relative strength portfolio - current holdings

Asset allocations - relative strength portfolio - current 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:

  1. Own the asset class if price > 20 or 40 week SMA
  2. Sell the asset class if prices < 20 or 40 week SMA
  3. An asset class will be owned at 11% of the portfolio, if owned
  4. For every asset class on a sell, the worst performing assets may be shorted to a maximum of 20% of the portfolio
  5. Only one signal or trade of asset per week.
  6. Sell on the week of the signal, buy on the end of month signal.
Top 3 asset classes - return comparison graph

Top 3 asset classes - return comparison graph

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.

Relative strength portfolio - statistics

Relative strength portfolio - statistics

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?

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21 Responses to Refined relative strength system for investments

  1. WorkSaveLive says:

    Whew! That is complicated. That’s pretty awesome all of it makes sense to you though.

    For risk I simply diversify to a great extent and keep my standard deviation as low as possibly while keeping the returns as high as possible. Markovitz’s efficient frontier.

    • Karl says:

      Well that is a bit disappointing as that means I didn’t explain things very well. At the most simple, the idea is to invest in the asset classes that have been doing well lately, as research has shown these assets then outperform in the following oeriods. This is really just optimizing that idea and choosing only the very best using the same idea. I still put a lot of stock in safety, thus the stop loss at the mkving average level.

  2. The fact that this was barely undersatndable to me, tells me that I have a lot to learn about investing. When you spend all your time trying to pay off debt, you ignore learning about the other end of things… investing!

  3. This is quite detailed and an advanced form of stock investing for the average investor. However, the one thing that that is important is to make sure that you have a diversified stock portfolio, and to have a balance of high-performing and low-performing stocks within your portfolio.

  4. Nick says:

    You know, it’s pretty interesting for sure. I like the low correlation if you were trying to diversify your portfolio – i.e. owning 30 different funds that track the S&P can be pretty pointless…

    I’ve been an index-fund ETF guy for a while, though – mostly as part of a simplicity movement. I’ll definitely keep up with the updates though. I love reading about investment techniques.

    • Karl says:

      Nick, most of the ETFs I use are some form of index, though not the entire S&P. For example, I may use an ETF that reflects the Thailand market or a US sector such as energy producers. I never hold individual stocks anymore.

  5. YFS says:

    I understand what you’re trying to do but, I think I’m just too lazy to research stocks at the moment so I just index. My policy is own the market and get long term steady gains. I do the most of my research and risk taking with real estate.

    • Karl says:

      Once the system is set up, the research is basically automatic for me as the decision is really just the assets performing the best, in this case over the last 3 and 6 month periods. I’d like to try my hand at real estate, but its a bit too illiquid for me at this point. I know that you’ve been doing very well in RE however.

  6. AverageJoe says:

    Incredibly enjoyable post. Better over a beer so we can discuss because I’ve got 300 questions. My main one, though, is the 11 percent line. I don’t understand that at all.

    BTW, YFS, this portfolio can be completed using indexes. It’s actually pretty easy to accomplish.

    Momentum plays and backtesting are always interesting to me because they’re usually built on the result of the backtest. However, the market doesn’t backtest. That said, using the SMA to decide buys/sells is intriguing, but it seems to me like the “one sale” rule ruins some of the effectiveness. Why is this in place? Which do you decide to sell?

    • Karl says:

      Joe, the main reason for 9 holdings at 11% each is really that is what fit with my existing system the best with minimal changes, I could have easily expanded it to 10 holdings and made the holdings look better at 10%. The other is that the 9-10 holding range gives plenty of protection against single stock risk (if not full diversification) while still giving good concentration in the top 3 asset classes.

      No, the market will change, and investment systems will move from periods of effectiveness to not so much and back over time. The SMA (20 week and \ or 40 week) provide a stop-loss because research has shown that market returns are about 10% on average when the market is above the 10 month moving average, and about -4% when the market is below. Additionally, volatility is almost twice as great when the market is below the 10 month moving average. So I avoid holding assets when they are below that line as a protection against larger losses.

  7. Whew….I felt like I was in one of my finance classes again!! A great though. I will be very interested to see the returns compared to the S&P 500 each month. Are the highlighted investments what you are going with in addition to others? I’d like to see what investments you end up choosing.

  8. I am with Jason and this is a pretty complicated system. While it makes sense to me it’s a little in depth for the average investor as most don’t have that much time to dedicate. I do like it and am looking forward to seeing how it works for you 🙂

  9. Hi Karl,

    Very interesting investment strategy. I look forward to how this one pans out! Keep up the good work and cannot wait to see the update on this. We do a lot of work with RSI based on chart patterns if you’re interested!

  10. Bichon Frise says:

    Tres complicated and a classical example of technical analysis. Isn’t this buying high and selling low?

    I certainly hope you get the returns you are seeking, and I look forward to your updates.

    • Karl says:

      Bichon, actually the theory behind momentum is buying high and selling higher. That is why having good money management and effective stops are important.

      • Bichon Frise says:

        How does that differ from the “greater fool” theory then?

        I don’t really understand what having “good” money management and “effective stops” means… :/

        • Karl says:

          In some ways there isn’t a lot of difference, however momentum has been a consistent and persistent edge that academics have known and written about for decades across virtually all asset classes. Good money management means a system that correctly sizes positions for given risk, cuts losing positions and lets winners run. With good money management, random entries can be profitable over time. As explained above, good stops for me are the 20pictured and 40lets week moving average, as volitility increases and returns decrease when the asset moves below these levels.

  11. A win percentage of 69% is great! You have a detailed and wonderful way of diversifying your assets. How often do you asset rebalanacing? Those top three aren’t always top three..

    Best regards,

  12. MagnumTI says:

    You mentioned shorting asset classes on a sell signal. Are shorting the ETF or buying the inverse ETF (If one is available). Are there any drawbacks to using that approach? Also, would love to see monthly results posted as mentioned…

  13. MagnumTI says:

    Sorry, one more clarification – are you defining an asset class as buy based on performance of an index or based on performance of the specific ETFs?

  14. […] at Cult Of Money writes “Refined Relative Strength System For Investments”. Back-testing this methodology with the same set of portfolio holdings as the original methodology […]

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