HPI^™10alpha Program (TaP^©)

A Diversified Portfolio

Improve your equity trading performance using proven performance management techniques

revised: 15 May 2019

Principles: Portfolio Diversification Matters and Measurement Enables Improvement

Objective: Establish portfolio diversification targets and begin the process of defining relevant metrics

Time to dive into our Principles. We will touch on Portfolio Diversification Matters on the way to the first installment in Measurement Enables Improvement.

Performance Management Background

When you consider improving performance, whether from a sports or business analogy, there is a common set of sequential steps to be performed:

• Have a plan

Call it a vision, strategy, goal, whatever, but get a clear idea of what you want to accomplish over some particular time frame. Benjamin Franklin was purported to have said, "A goal without a deadline is a dream". Your goal may be to put kids through college, retire early, enjoy some interesting destination vacations or something else entirely. The point is to have some target in mind, set it down in writing and revisit it three or four times a year.

• Communicate

That may be with your significant other, a family member, whomever. Engage others who may help you achieve your goals and stay focused upon them. They can also hold you to account when you lose conviction or focus.

• Establish intermediate objectives and measures

Call it "Eating the elephant one bite at a time", but large, important goals are rarely achieved in one step. If your goal can be, spend a bit more time thinking big.

• Track performance

Establish simple systems to provide measures; adjust behaviors or actions as necessary to achieve intermediate objectives leading to accomplishing the goal. As management guru Peter Drucker is credited with saying, "You can't manage what you can't measure".

Statistician W. Edwards Deming might have said, "In God we trust, all others must bring data". To be effective, the data you collect must be readily available as a natural consequence of what you do. Creating a cottage industry aimed at providing data and summaries will not stand the test of time. "Keep It Simple".

It is incredibly important to establish a data driven approach to management of your investing performance. People are naturally optimistic and possess an amazing capability to, as Bing Crosby sang, "accentuate the positive, eliminate the negative". There are conditions under which this is useful. Investing is not one of them. We will likely cover some of the cognitive biases being studied as part of Behavioral Finance where they apply.

If done properly, data collection to support decision-making can be automated to provide daily insights significant without  effort.

• Rinse and repeat

As you review results and draw conclusions, adjust your actions to drive performance toward your goals. Stop doing what is not working or adjust the way in which you do those things; emphasize what is working. At the same time, recognize the environment within which success and failure is happening and establish measures that enable you to recognize when that environment changes.

Whether it is interest rates, strength of the dollar, price of oil, apparent rotation from cyclicals to defensive equities, growth to value, or whatever, it is important to recognize and take advantage of changing market dynamics. The alternative is to be caught zigging when you should be zagging.

• Continuous learning

It may well be that you already know everything there is to know about investing and do not need to educate yourself further. Congratulations -- now get real. The environment within which the market operates is ever-changing. As Darwin may have said, "Adapt or die". Establish some goals that have to do with "sharpening your ax".

Consider the possibility that your perception of your trading activity might not reflect reality. There may be two types of people -- optimistic or pessimistic. Depending on your bias, it can be easy to gloss over losses or blow them completely out of proportion. It may be you only see the winners or only see the losers.

We must have relevant, timely and accurate data to evaluate. Only with that can we approach decision making with a rational, unemotional assessment of how we are doing irrespective of our internal bias. With data and a rules based approach, we can reduce losses while extending gains, thereby improving performance.

We will spend our time looking at options. Options are less stressful than commodities trading, more interesting than bond watching and faster paced than stocks. Most of the examples will be mid- to long-term, meaning 90 days or longer -- up to a year and sometimes more.

The techniques outlined will work with any of the investment vehicles. What changes for performance management is the interval for reviews and in some cases defining what data is important. For stocks, monthly reviews; for mid- to long-term options, weekly reviews; weekly options require daily reviews as does day trading. We will develop the most relevant data elements to collect and track.

"While I did day trading for nearly a year, and on the whole was successful, it was really detrimental to my golf game.

I encourage people to do 6 months or so with a trainer, whether paper trading or not, as there are many invaluable lessons given the purely technical trading approach required."

The plan, communication and intermediate objectives are specific to the individual and we cannot effectively cover them. Our focus is on tracking performance.

We need to lay some foundation and establish a practice portfolio to ground the examples.

Strategic Context: How to Establish a Target Portfolio

It would be nice to simply stipulate that diversifying your portfolio is axiomatic and therefore needs no discussion. However, there are a few nuances to consider.

The key element is to mitigate risk with diversification. There are many writers out there with a better handle on describing the risks and alternatives that you should look into.

Given that, however, there is not a great deal of material regarding "trade type" risk management. We will go into this further as our metrics develop. Meantime, consider that you may find your trade portfolio, a different entity than your asset portfolio, may be overweight long volatility trades; you may inadvertently find you have few or no bear trades. And the list goes on.

There are many services available through the internet that aim to provide you with specific trading tools or techniques. These services then endeavor to expand that single technique into a "model portfolio".

For example, one service focuses solely on trading equities that exhibit a clear Dow theory pattern of higher highs and higher lows. Another is focused on Fibonacci retracement levels. Another sticks close to momentum stocks.

While each of these techniques is useful and has its place in the toolkit for technical trading assessments, taken singly it is not possible to create a diversified asset portfolio and certainly cannot deliver a diversified trade portfolio.

So, suffice it to say that we will be working asset diversity and trade diversity. The major learning is that no single trade tactic can provide trade or asset diversity.

We need a strategic view of the market environment in a way that enables us to create a target asset portfolio. This target needs to be monitored as it is what provides the appropriate diversification of the portfolio.

For our purposes, let's take the following position as we look forward into 2018:

• Monetary and Fiscal policy

Using GDP is important but not sufficient by itself. An economy may experience rising GDP in parallel with rising costs of living. Monetary and Fiscal policy are perhaps the yin and yang of economics.

Monetary policy may be restrictive or expansionary and is managed by central banks. The primary objectives are to manage inflation and reduce unemployment.

Fiscal policy may also be restrictive or expansionary but is managed by the elected government. The primary objectives are to enhance re-election so the tendency is more toward expansionary.

Our forecast for Monetary policy is mildly restrictive with the Federal Reserve expected to raise interest rates 3 or 4 times in 2018 (4 more problematic than 3); continuing to target low unemployment somewhere near the natural rate of 4.7-5.8 percent; holding core inflation to 2-2.5%; and retaining a healthy economic growth at 2-3% annual increase in GDP.

Our forecast for Fiscal policy, as evidenced by the tax code changes, growth in defense spending and infrastructure spending, etc., is for continued expansion.

Taken together, this should be a good year for investing overall while we do need keep our eye on the policy indicators. If these conditions change, we will change with them.

• Portfolio implications from strategic context
  • Prefer cyclical to defensive stocks
  • Prefer stronger correlation to rising interest rates, e.g., financials, consumer discretionary, industrials, durable goods
  • Consumer spending is about 75% of GDP; tax reductions for both corporations and individuals will provide more discretionary spending
    • Retail has been under-performing as part of Consumer Discretionary so provides a target
  • Energy service companies will likely come back faster than other parts of the energy sector as fiscal policy strives to increase U.S. production beyond 11 million barrels per day
  • Fiscal policy looks to increase defense spending
  • Fiscal policy impact may increase later in the year as infrastructure spending plans mature: Basic Materials such as steel, concrete, etc.
  • Potential for a rotation from Growth to Value
    • Technology was such a strong performer last year, backing off initially may be wise
  • Recognize that 0 is not necessarily 0 as some targets of opportunity may show up that enable a small presence at the right price as a beach head for sector rotation

We will start with an established portfolio of options on stocks with a target distribution as indicated below:

Our first measure will be to establish tracking by sector percentage and compare that to our targets. There is no science to establishing these targets. We have broadly increased exposure in alignment with our strategic view and reduced elsewhere to make up the difference.

• Caveats and recommendations

Be aware that the source you use for sector assignment of stocks may not be correct for portfolio management

For example, Biotechnology stocks like Celgene and Biogen are in the Healthcare sector, which is correct but not useful for portfolio management. There are distinct differences between Energy service companies, refineries, oil and gas exploration companies yet they are all in the same sector.

We will start by using the Exchange assigned sectors but leave room to use Industry rather than Sector. Sectors listed above the blue line are standard; those below have been created to aid portfolio management.

Consider establishing a portfolio base with a couple of ETFs. Having an S&P index fund and a Russell 2000 index fund in the portfolio enables us to make easy benchmark comparisons of our performance to that of the market while providing that foundation.

Do not forget Cash. Insufficient cash reserves precludes us from taking advantage of opportunities and can cause some poor decision-making on downturns.

Finally, note that the target diversification exceeds 100% - we are not there yet ...

Principle: Measurement Enables Improvement

We would like to see a simple display of our performance against our targets for the portfolio. It might look something like this:

Next Time

Given our first performance metric, we need a way to track it. The best start point is to establish a trading log. We will take that on next time along with a process for establishing a stable of equities we will use for trading.