How We Manage Money
to Reduce Risk

There are a ton of ways to invest your money on the public market and get exposure to domestic companies, international organizations, or any number of different asset classes like the ones determined by Morningstar.

You can buy stocks, bonds, real estate—and that’s just the beginning.

If you’re willing to spend some time doing research, you can go further down the investing pyramid—deciding whether to buy and hold individual stocks or let index funds do the investing for you. You can purchase a couple active mutual funds, or actively trade a portfolio on your own.

Here at Potomac, we’re a tactical money manager that specializes in risk reduction. Our chosen investment vehicles are mutual funds and ETFs. Like with many terms in finance, though, the definition of a tactical manager can vary among those who practice this type of management.

So, let me be clear about our tactical investing beliefs. Here’s what we believe.

• We believe you need to reduce risk by managing your maximum drawdown.
• We do not believe you need to be exposed to equities or any other asset class, 100% of the time.

There will be periods when you need to reduce your overall risk levels, whether because you’re about to retire or the inherent risk in the market at a given time doesn’t match your tolerance for risk.

But let’s make one thing crystal clear: there is no perfect investment style and they all have their flaws.

Tactical investing is no different! For us, however, this approach is the best style of management to reach our goals of generating returns for our clients and avoiding the catastrophic drawdowns that can devastate a portfolio nearing or in retirement.

Our management process can be broken down into two categories, which I’ll spend the rest of this blog discussing.

Once you’re finished reading, you’ll understand Potomac’s process to determine how much risk we believe a portfolio should take, and how we decide where to invest.

How Much Risk Should We Take?

The first step in our investment process is to identify trends that indicate the strengths or weaknesses in the current market environment.

The fundamental question we are trying to answer is, “How much risk is currently in the market?”.

Once we make this determination, then we review whether we want to be fully invested or should we raise some cash to take some risk off the table.

Our process analyzes a universe of over 100 technical trading indicators built on a robust technology platform. Each indicator is rigorously tested on an individual basis to determine which combinations provide the best indication of market direction. The technical trading indicators are then combined into sophisticated algorithmic composites that guide our decision-making process. Let’s dive into our process a little deeper…

Our composite trading systems are simply a combination of base and trigger systems.

Base System: Trading systems that trade infrequently to capture long-term trend changes. They typically cover multiple data points over a longer time horizon.

A good example of one of our base systems is our Intermediate Momentum System, which is a riff on a system originally created by the late Nelson Freeburg.

It is a point-based system that examines the long-term moving average crossover of five data points: The S&P 500, NYSE Advance Decline Line, Dow Jones Transports, Dow Jones Utilities, and Dow Jones Corporate Bond index.

The reason we consider this a “base” system is because it covers a wide range of data points including a broad market and breadth index, in addition to both economic and interest rate sensitive indices.

If all five data points are above their long-term average, the trend would be considered bullish. If three out of the five data points fall below their long-term averages, that would be considered bearish.

This base system could be used on its own with great success. It would give every investor a “process” to exit the market when long-term trends break down. Like anything else, however, it’s not perfect and requires discipline to execute.

We then take a base system like our Intermediate Momentum System and add various Trigger systems.

Trigger Systems: Capture short-term market inefficiencies that generate high returns while invested.

There are many trading systems that can generate short-term returns—but frankly, they don’t happen very often. So, for them to be effective you need to add these to a longer term “base system” model.

A great example of a “trigger” system is a Volume Burst system that measures extreme bursts in the NYSE trading volume. Historically, a short-term volume burst is followed by a short-term market advance.

The above system is quite simple in that you are looking for a short-term volume burst, and you would hold that trade for only 15 days. Obviously holding something for 15 days after one technical occurrence is ridiculous and not a standalone strategy.

But imagine if you could find numerous trigger systems, that when added to a base system, are able to generate excellent risk-adjusted returns.

We continuously repeat the process of analyzing the combination of both base and multiple trigger systems. The result gives us an idea of the current investing climate and how much risk we are willing to take.

This is how a composite trading system designed to tell us how much risk we should take on is created.

Source: YCharts 12/31/2018

Where Do We Want to Be Invested?

Conventional asset allocation promotes being well diversified across a variety of asset classes. In theory, if your assets are spread out you decrease the likelihood of an underperforming asset class taking down the entire portfolio.

Let’s look at a strategic buy and hold moderate allocation from Schwab. We aren’t picking on Schwab, as virtually all custodians have a similar strategic “buy & hold” portfolio for sale built on generic diversification principals.

While small changes may be made over time, overall this portfolio will hold this breakdown of asset classes in perpetuity. 

We don’t believe in always diversifying among asset classes.

Yes, you heard that correctly, we don’t believe in diversification in the traditional sense.

While it’s important to diversify your trading strategies or style, blindly holding an asset class in perpetuity doesn’t make much sense to us.

International stocks have trailed the US for over 20 years on a risk and return basis, but traditional buy and hold diversification has continued to recommend you hold a certain percentage of them.

Our belief has always been to hold the right asset class at the right time, otherwise known as momentum or trend following. We want to actively tilt/shift our exposure to those few asset classes that are performing well for the current market environment.

For example, look at the modified Callan chart below. For purposes of this argument I adjusted it to a shorter time horizon to cover just 2018.

The hallmark of momentum or trend following is to follow the winner i.e. buy high and sell higher!

For example, let’s look at the Small Caps in 2018. Throughout the year, our goal is to overweight each of our core equity portfolios to an asset class (like Small Caps in this example) as it rises in the rankings, and then exit stage left when the short-term trends begin to break down.

Different risk levels will necessitate different percentage allocations, and these strategies don’t apply to everyone, but you get the point…

Long-Term Investing Success is Personal

Markets are cyclical and the current investing de jour is passive investing. While passive certainly has its benefits, the risk levels associated with that investing strategy are just too much for many investors—including myself. Therefore, we developed another way to approach investing with the concept of risk, front and center.

We don’t live in charts, so telling an investor to sit through a -50% decline and living through that decline are vastly different experiences.

The truth is that there is no perfect investing style and the only ones who promote otherwise are charlatans.

Ultimately, the first step for every investor is to develop their own personal tolerance for risk.

Once you’ve set your risk tolerance, start working backwards to determine what investments appeal to your score. Just like a diet, the best investing style is the one you can stick with for the long haul.

Happy investing….