Opportunity

Investment Objective

Sometimes, we invest not with a specific and important financial goal in mind, but simply to make the best out of what we’ve got. We could summarize the investment objective as follows:

• Deliver high returns, with volatility being of little concern
• Suitable for the Investing Excess Funds scenario
• Optimized for high average returns
• Intuitive mechanism
• Moderate maintenance requirements

In simple terms, we go out on a limb and take on significant investment risk. If we get lucky, we might use our gains to satisfy lofty goals, or we might just pass on this wealth to the next generation. And if things don’t work out that well, we might not be able to buy a yacht, but we still make rent and put food on the table.

Strategy Construction

Top-Level Architecture

From a 10,000ft perspective, the Opportunity strategy aims to make a very simple decision: should we invest in asset A, or asset B? However, Opportunity makes this decision based on a novel concept, looking at both asset’s trend direction, and at the potential outperformance of one asset versus the other.

If, based on these observations, Opportunity identifies a clear winner, it invests in that asset. If it fails to identify a winner, the strategy goes into an ‘I don’t know’ state and invests in a 50/50 mix of both assets. And if the strategy determines that both options are likely bad, it invests in a ‘safe asset,’ which may or may not be identical to one of the original assets.

After much testing, I decided to set up the strategy with the following assets. Of course, other setups are possible:

• asset A: US large-cap index fund
• asset B: Safeguard strategy
• safe asset: Safeguard strategy

In the way the strategy is constructed, it specifically avoids the calculation of momentum. This is motivated by the observation that there are periods in time, where momentum collapses, and momentum strategies underperform strategic portfolios.

The inclusion of the ‘I don’t know’ state allows the strategy to make a solid and stable compromise, in situations where other strategies might tend to whiplash and unnecessary churn, significantly hurting their performance.

Trend-Following

Opportunity’s trend-following mechanism is among the most complicated I ever built. It is a majority-voting mechanism, based on numerous independent indicators:

• Inverse Z-cone
• Simple logarithmic regression
• Multiple logarithmic regressions w/ walk-forward optimization
• Short-term vs long-term momentum divergence

Inverse Z-cone

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Simple logarithmic regression

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Multiple logarithmic regressions w/ walk-forward optimization

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Short-term vs long-term momentum divergence

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Decision Matrix

Using the trend-following mechanism described above, the Opportunity strategy calculates the following indicators:

• asset A trend
• asset B trend
• asset A outperformance (trend of asset A / asset B)
• asset B outperformance (trend of asset B / asset A)

With these four indicators, we build the following decision matrix. It is worth noting that, due to the nature of the indicators in play, some ambiguous/ non-sensical combinations exist:

In this decision matrix, we can distinguish the following areas:

• clear asset A preference
• clear asset B preference
• asset A and B rising, but unclear leadership
• asset A and B falling

In my testing, especially the blend of assets A and B improved the strategy’s behavior substantially. It is these areas, where a momentum-based strategy would likely flip-flop between the assets, and take a high risk of ending up on the wrong side. In comparison, Opportunity has a more stable asset allocation with less churn and better diversification.

Strategy Results

Our investment objective above stated ‘high returns’ as the prominent goal, without defining what this really means. In my interpretation, high returns refer to a strategy that can keep up with the broad stock market in bullish years while, hopefully, doing better in market downturns.

The Monte Carlo simulation shows an impressive result. In the long term, Opportunity captures all of the market’s upside at the 95th percentile, while significantly improving returns at the 5th percentile. As a result, the average returns also increase substantially.

The expected range of investment outcomes is significantly slimmed down, indicating much reduced volatility. As a consequence of this, Opportunity greatly reduces the expected break-even period. Also, the expected recession drawdowns are less than half of buy-and-hold, with recovery also taking less than half of the time.

The cumulative return chart illustrates the strategy’s docile behavior. Opportunity has managed all major drawdowns extremely well, including slow recessions, and fast market crashes alike. Even better, the strategy has no difficulty jumping back into the market to capture a fast rebound, like in the 2020 COVID case.

Putting the above findings together, it comes as no surprises that Opportunity is able to capture most of the market’s upside, while at the same time avoiding a significant portion of its downside. As a result, the strategy gains on every major market turndown, delivering tremendous upside over buy & hold. The rolling return chart above illustrates these claims.

Opportunity‘s metrics show how much value the strategy delivers to investors, beating its passive benchmark across the board. Even though the risk-adjusted returns are less relevant for the Investing Excess Funds scenario, they show the strategy’s quality. However, the low beta document’s the strategy’s willingness to take trades, while at the same time staying invested throughout bullish periods.

Conclusion

In summary, the Opportunity strategy is an aggressive investment, without taking undue risks. It is an excellent choice for investors seeking to grow their wealth without having specific financial goals in mind. Also, it is an ideal ingredient to spice-up portfolio blends.

Regardless of all the simulations above, investors should be aware of the strategy’s tail risk. Because Opportunity invests up to 100% of the capital into the broad stock market, its tail risk is identical to the broad stock market. If the strategy is confronted with situations that weren’t tested in the simulation period, it may expose investors to this risk.

Consequently, investors should not take this risk lightly, when they don’t have to. Especially when Investing Toward a Goal or Investing for Income, the strategy presents a risk that does not pay off.