This blog post is on managing emotions associated with trading so that you avoid letting your emotions getting in the way of your making money. I had taken some of these as granted because of my experience with trading, but not all of my clients are prepared for the emotions. So this is an attempt at education on helping make the right trade-off decisions between risk and return.
I will be putting this blog as “mandatory” reading in the “Getting Started” section.
Let risks determine returns, not the other way around.
I have had a number of clients who have joined based on the returns. They have “heard” that the high returns (40-45%) associated with the Risk Parity – Platinum algorithm comes with a 20-25% risk, but are not necessarily prepared for that.
The Risk Parity algorithm trades in Stocks, Bonds and Gold. Given time, any combination of investment in these assets will always make money. Read the blog posts here and here to understand more. The key to making money is to avoid drawdowns and in the process maximize returns. Risk dictates return, not the other way round.
So a risk of 20-25%; provides a return of 40-45%. A risk of 50% can be made to provide a return of 80-90%. What is the risk level you are prepared for? Let the risk be the decider of returns not the other way round.
I have had one client who dropped out at the end of October 2020 since the drawdown was 13%. When the model recovered in November and December, he wanted to get back in. This will not work in the long run.
If you do not want to take a 20-25% risk, go with the gold or the silver models of the risk parity algorithm. They are the exact same algorithm, except that they target a lower risk profile. You need to target a risk profile that you are comfortable with, so that you do not run the risk of taking emotionally charged decisions.
Understand the “Neighbor’s Envy” emotion
Suffering is relative. It was interesting to see some of the human psychology play out in conversations throughout the year. When the stock market goes down and your portfolio goes down, most people find a way to explain that away. Everyone else is suffering, so my suffering is not that painful. However if the stock market is going up and your portfolio goes down, I guess that pinches more!! Many of the questions I got on portfolio allocation were from clients whose neighbor had bought Tesla or Amazon and made lots of money when our portfolio was going down.
All of you will go through the emotional up and down at some point. You will have moments where you will feel “Neighbors Envy”. Take a deep breath. This too shall pass.
A 20-25% drop in portfolio if not more is guaranteed. It may happen now, it may happen next year, but happen it will!! No investment goes up in a straight line. There will always be ups and downs. The degree of ups and downs is what will vary between different investment vehicles.
Do you want to be Keanu Reaves or Adam Sandler?
The risk-parity algorithm is “Adam Sandler”; slow moving, not a impulse decision maker. Decisions are made based on weekly and monthly data rather than hourly and daily data. In the attempt to manage “risk”, it will increase cash exposure when there is high volatility in the market. In the process, you may have periods where the stock market is rocking it, but the algorithm prefers to stay out to reduce risk. This is normal and intended behavior.
Which Lane is faster?
Imagine driving down a highway. You are in a hurry to get to your destination, so you keep switching lanes. Now consider the three lanes to be Stocks, Bonds and Gold. You are essentially switching between these lanes to try and make “more” money. If you stick to any of the lanes you will still reach your destination and make money. Intention of switching is to get there faster or make “more” money. Sometimes the lane switching works and sometimes it does not work. As long as you get it right 60% of the times, you are good. You cannot get it 100% right!! This is exactly what the Risk Parity algorithm is doing; using fundamental and technical variables to determine when and which lane to switch to.
See the Risk Parity Platinum monthly results below. Unfortunately, getting stuck in the wrong lane can be for a period of a few months. The “red” triangles below are points in time when if you had joined, you would have seen drawdowns ranging from 15-20% before you saw the portfolio get back in the green. The “red” btw are not correlated to the stock market. You can see “red” in your portfolio even when the stock market is doing very well.
This is the reason, why we subsequently added the Risk Parity Swing and the Risk Parity Innovation algorithms to the portfolio. They provide the same diversification between the lanes as Risk Parity Innovation, but they drive differently.
Disclaimers and Licensing
Read our disclaimer and our licensing agreement before you proceed. By continuing with the set-up you are implicitly agreeing to these. I have tried my best at simplifying the licensing arrangement to keep it simple. Please read it before you continue.
