3 Secrets to Make Money in any Environment

Every Tuesday Chuck releases a new Trader Tip video on YouTube. This week we will discuss how the three secrets to make money in any environment: 1) by focusing on strategy allocation, instead of asset allocation we can do a superior job of managing our risk, 2) by diversifying through uncorrelated strategies, we can significantly reduce her risk and 3) by building strategies that benefit in each of the four economic seasons, we create portfolios that are robust enough to make money in any economic environment. Watch the Trader Tip Episode for more information!

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

Going back about a year ago, Mark and I started pounding the table to the fact that modern portfolio theory was broken. We could see a scenario unfolding in which the stock market would break, and bonds would break with it, causing immense pain for everybody. Fast forward a year later, and that's exactly what is happening. The traditional 60% long equities, 40% long bond portfolio is getting destroyed in 2022. It's actually down 12.8% year to date. 2022 is one of the five worst starts for a year for stocks and bonds since 1939. In the last 30 years, bonds have acted as a hedge against equities. So anytime stocks broke bonds would rally. The impact was the bonds would help mute losses in the portfolio, and so they performed an important function. That is what modern portfolio theory was based on was that if stocks went down, bonds would go up, and they would play off each other. But when rates go to zero, there's no place for rates to go but up. And that's where we got. We got to a point where short term interest rates were zero, the long term interest rates were very, very low, and people couldn't earn any money in bonds anymore. It's actually becoming even more dangerous than this. Because not only it was a 60/40 a loser, but a lot of people felt like they couldn't make money at all in bonds at all. So they just put more money into equities. You have a lot of people that are 80, 85, 90%, long equities, and they really get killed.

This year, both bonds and stocks went down together. What? Why is this? What's going on that's different. Well, one, we said interest rates were too low. But second, this break has been happening in the backdrop of high inflation, and because there's high inflation, the modern portfolio theory that portfolio has nothing to handle inflation. We're going to talk about this more today. Let's talk about the three secrets to make money in any environment. If you get these three secrets, right, you can make money virtually every year, and you can do it on a fraction, a fraction of the risk.

The first secret is a simple approach to reducing portfolio drawdowns is instead of doing asset allocation, it's actually to do strategy allocation. In a strategy allocation approach, we allocate money to a strategy, and that strategy has its own risk metrics, its own risk rules. This strategy could go fully to cash or is just allocated to an asset. A classic example might be an asset allocation, you're 60% equities, 40% bonds, and they might hold back a little bit for cash. But you're always long equities, and you're always long bonds. In strategy allocation, you might allocate 60% equities, but you might put it in a equity strategy, and the impact of that is, even though you have 60% allocated to equities, it sits in a strategy which any given point, it might be 60% long, it might be 30% long, it might have zero exposure, and it has risk points where it takes the risk up and down somewhere like what we would do with an initial stop. This has the impact. In asset allocation, you're trying to manage the risk through how you allocate to assets. In strategy allocation, you're putting the risk inside the strategy and you're managing the risk inside the strategy, which has the impact of dramatically reducing the risk. That's why this is so important. This approach can simultaneously enhance returns and reduce risk.

The second secret is to diversify across three or more uncorrelated strategies. Now Ray Dalio is a founder of Bridgewater, who built the largest hedge fund in the world. Bridgewater is the largest hedge fund in the world. Ray has said if we can invest in three uncorrelated strategies, we reduce our risk by 50%. If we can invest in 15 uncorrelated strategies, we can reduce our risk by 80% and improve our return to risk ratio by five times. Now, this approach is especially pertinent now as we are an inflationary backdrop where both stocks and bonds are not performing. A portfolio of strategies, rather than a portfolio of assets will enable your portfolio to perform well under different economic conditions. The goal is to get a minimum of three and hopefully more like five to 10. If we're able to do that, that's going to have a big impact on reducing drawdowns and creating consistent returns.

Now, secret number three is the best portfolios are ones that can withstand any of the four economic seasons. The four economic seasons are inflation, deflation, economic contraction or recession, or economic expansion. The modern portfolio theory is based off of deflation, and economic expansion. It did not address inflation, or recessions. Now, we want to think about how do we have strategies that perform well in any one of these four seasons, and if we have uncorrelated strategies, let's just say that we have one strategy for each season, we could put them together, we're going to have a portfolio that is robust, and has a chance to be consistently profitable. Now my partner Mark produces a newsletter called the Portfolio Strategy Letter (PSL), it comes out once a month, and one of the things that we can see is that in Portfolio Strategy Letter, Mark has built it with 15 different strategies, and these strategies do well some of them do well in some seasons. Other do well and other seasons.

Here's just the example of strategies that do well in inflation, and in deflationary environments. They play off each other. One of the strategies we have in here, which you can see is the top row diversified high yield,. The diversified high yield portfolio, which is in Portfolio Strategy Letter benefits from all four economic seasons. The result is a strategy that's returned greater than 10% a year, on average, over 30 years, with a max drawdown of about 12%. It's made money in 29 out of 30 years, 2021 was the first losing year it ever had, and it was only down 2%. This year, high yield is up nearly 5% versus a 60/40 portfolio which is down almost 13%. So high yield has outperformed by over 17% versus the 60/40 portfolio this year.

Here are the three secrets, just reviewing the three secrets to make money in any environment 1) by focusing on strategy allocation, instead of asset allocation we can do a superior job of managing our risk, 2) by diversifying through uncorrelated strategies, we can significantly reduce her risk and 3) by building strategies that benefit in each of the four economic seasons, we create portfolios that are robust enough to make money in any economic environment. So many people focus on building like the perfect system. I want you to hear me, you don't need the perfect system. You need a blend of good systems that each pull their weight in different environments, and if you're able to do that, you can create a portfolio that kicks butt. So think about this. Think about the three secrets, and what could you do to start to have your own uncorrelated portfolio.

You're going to want to watch this Trader Tip Tuesday more than once. I will see you next week. Stay tuned every Tuesday for additional webinars, where we will teach you different ways to think about trading to take your performance to an elite level, just like today. So have a great week! God bless, and we'll see you next Tuesday, bye.