How are you controlling portfolio risk as we enter an uncertain market period due to the coming contentious election and the ever present Covid-19 pandemic? Are you paying attention to the portfolio risk exposure or do you intend to ride out what might be a volatile period for equities? With bonds earnings very low, is it time to focus on low volatile securities and how might one do that?
Rather than attempt to explain in verbiage what one might do, let’s take a real portfolio and walk through the process of how one might apply risk management to a live account. As a point of interest, the owner of the Einstein is very interested in protecting capital so this portfolio is useful when it comes to showing how the Kipling spreadsheet can be used to mitigate portfolio risk. Since this post is open to all readers, a complete analysis of the Einstein will need to wait until later in the week.
Einstein Investment Quiver
We begin with the investment quiver. The Einstein is built around market Factors and is supplemented with “missing” asset classes such as gold, real estate, and international equities. An area that is missing is an ETF that focuses on holding low volatile ETFs. That feature is built into the look-back settings within the Kipling spreadsheet so that area of interest is not quite so important.
I deviate from the default settings you receive with the Kipling and those are the Strategic or Max Asset Allocation percentages. What you see below are my personal judgments. One change I’ve made in a number of portfolios, and plan to change in the Einstein is the percentage allocated to VTI. I plan to move the percentage from 40% up to 100%. I’ve explained elsewhere on this blog how those percentages work.
The Max AA percentages are the first risk protectors as they limit how much is invested in any one ETF.
Einstein BHS Recommendations
The second major worksheet is the Tranche. In this worksheet I’ve set the investing model to Buy-Hold-Sell (BHS) and the Target Filter is turned on. A Yes setting for the Target Filter simply means we will not invest in any securities that are performing below VTI. Since the current rank of VTI is six (6) [5th column from the right] and the maximum number of assets is adjusted to five, the Target Filter does not come into play.
The five Buy recommendations are: QQQ, QUAL, MTUM, HYT, and SLV.
Einstein Position Sizing Recommendations
Now we come to the second way to control portfolio risk and this is a major one. Check the red arrow. By setting the Maximum Trade Position Risk to 1.00% we limit the Maximum Portfolio Risk to 5.00%. See the black arrow. With these settings we reduce overall portfolio exposure. However, we end up with a lot of cash. See the yellow arrow.
For a portfolio of this size, to end up with $95,000 in cash may well be too conservative for most investors. If this is the case, then elevate that 1.00% setting to something higher as that will automatically readjust how much cash the money manager wishes to leave in the portfolio. If you decide to run the cash to zero, there is still another way to protect risk to the investments. More on this a bit later.
Einstein Manual Risk Adjustments
The Position Sizing recommendations from the above worksheet automatically flow into the worksheet below. The manual risk adjustments are where the money manager makes the decision as to how many shares to buy or sell.
As an example, the Position Sizing worksheet recommends the portfolio hold 111 shares of QQQ. I’ve manually set the number to 110. Since the Einstein currently holds 10 shares, the recommendation is to purchase another 100 shares (5th column from the right). If you look down the Shares Required column, you will see how many shares to buy and sell to meet the Position Sizing recommendations.
There is something else to note in the recommendations. HYT and SLV hold 11% and 10% of the total portfolio respectively. If you go back up to the first screenshot or the investment quiver, you will see that I limited these securities to hold no more than 10% of the portfolio. HYT adds that 1% as I manually entered 2430 instead of the recommended 2428 shares. Due to the 10% limitation on these two ETFs, QQQ, QUAL, and MTUM receive a higher percentage than otherwise would be the case.
There is one last method I use to protect capital and that is the use of TSLOs. In the Position Sizing worksheet I set the SD Multiplier to 0.75. With this setting, the Kipling spreadsheet comes up with recommendations for TSLO percentage settings. Once more, an example is the best teacher. Suppose we are reluctant to sell VWO as it has a rank of 7 and a score of 10. Check the second screenshot above. Instead of selling VWO immediately, we place a TSLO under the 230 shares of VWO. But what TSLO percentage should we use? If one follows the advice of the Kipling, check the 8th column from the left and you will see the recommendation is 7.3%. If the broker does not permit fractional settings, I would use either 7.0% or 8.0% for the VWO TSLO setting.
This last option of using some sort of stop loss order is the final backup to protect capital or to reduce portfolio risk. More sophisticated investors will use Options. HedgeHunter has recently posted a number of articles on this subject so look for the Options category if this is of interest.