Professional Advice and the Future of Risk Management

There is an old adage on Wall Street that says, “Good trading techniques come from experience, and experience comes from bad judgment.”  Most of us have made investment decisions that we would love to take back, but after learning from our mistakes we look forward to the situations we have mastered.  In the year 2000 we moved into a three year market decline that would absolutely devastate most portfolios. In twelve years we have seen market draw downs of more than 50% two times, and we all know that when an investor loses 50% of the money it takes a 100% return to make up the loss!

Life expectancy has increased since our Grandparents’ generation. Most sixty-year-old people still need to have growth assets to combat inflation, rising healthcare costs, etc., but asset management for a senior is much different than that of a person still in the accumulation stage. Extreme drawdowns have a devastating effect on the senior’s portfolio, so good sell discipline is imperative.

People could choose to allocate all assets to the fixed side of the ledger, but with returns projected to be low for years to come, most of us would agree that the easy money in the fixed income arena has been made. The savvy investor recognizes the huge price increase of the long bond toward the end of 2011, and knows how quickly those returns can evaporate if the investment community develops an appetite for stocks.

I want to describe my program called “Q.” My colleagues and I developed the trading strategies through training, experience, and study at a major Wall Street firm managing stock and bond portfolios, and with the assistance of my close friend and classmate at Ouachita Baptist University in late 1980's, Professor Darin Buscher.

I have been managing client portfolios for fifteen years. Professor Buscher has taught math on the University level for fifteen years, so we decided to bring the two disciplines together. We combined my trading experience with quadratic and linear formulas and started testing about eighteen months ago. Our goal was to place into the hands of the investment professional a tool that will replicate their risk management principles at the click of a mouse. We also want to provide constant portfolio monitoring and send text or email messages to the manager when an adjustment needs to be made.

A. We generate Buy and Sell signals through quadratic algorithms.

B. Stock or Bond funds are placed in the test line, and a test date range is selected. The algorithm solves for a projected value of 2, or a particular range we might select.

C. The values that make up the data lines are values we have assigned to the attributes of slope, momentum, and trend, or to the attributes we choose, and we have found to be successful over thousands of observations.

D. The conditions produce the signal – Sell or Buy – it’s not emotion or our opinion.

E. The back-test gives the result for what has already happened, and how our strategy would have done over the date range.

F. Forward signals simply use the same criteria for selecting stock or bond funds we have used in the back-test. When conditions are met a buy or sell signal is produced.

G. We use closing prices to avoid multiple signals through the day.

The program records and prints the date of the buy or sell trigger. You can see the (+) or (–) signs in the lines of data; and we can provide them on a flash drive. The program is searching for 3 + signs before passing through the last quadratic formula. There is an incredible amount of data, since we can test the process back to the early 1950s.

The signal history is plotted on a chart so the portfolio manager can visually review how reliable the signal has been.  The manager can choose to be long or short in the equity or bond markets. The program produces signals for fixed income securities and equities; fixed income generally goes through a more stringent testing process for location along the yield curve.

This is not a day-traders’ program; we work under the assumption of invested portfolios, risk is managed.  Since 2000, we have had 24 equity buy signals, and 21 of those signals have been profitable. Because of the increasing intersection of technology and financial management, the development of new programs such as the one my colleagues and I have created opens the door to more efficient risk management and better accountability.