A Relative Strength Asset Allocation Trading System
The market can remain irrational longer than you can remain solvent.
-John Maynard Keynes
In the first chapter I presented a static asset allocation investment strategy where international stocks, commodities, bonds and forex were used to decrease the overall volatility of a properly structured portfolio while maintaining return characteristics. Diversification obviously reduces risk, and asset allocation analysis is important because it enables us to assign a value to the expected risk.
The main weakness of the static model, however, is that it relies on historical returns to calculate the risk-adjusted return of the portfolio asset allocation. Rather than rely on historical returns, a more comprehensive and dynamic approach is needed when making trading decisions. This criticism is generally valid as historical returns are very unlikely to be repeated in the future.
Take, for example, the performance of the stock market from 2000 to 2007. An investor who bought an S&P index fund in 2000 hasn’t made any money, whereas another investor who bought the same index fund in 2003 has had a 70 % return on his investment. In addition, historical returns are not the only variables that can change over time because, as I have demonstrated in Chapter 5, correlations between asset classes can also change. For example, the correlation between stocks and bonds has been highly unstable during the last four years, with the correlation coefficient ...