Thanks Yuval and Rich,
I just want to add that Rich’s comments (principle component analysis or PCA above) tie in well to what Yuval is saying, I believe.
Historically at least (things could change going forward for sure), PC2 or what I called “risk off” above should have close to zero “market beta.” An interesting thing as Yuval correctly points out I believe.
I will probably be looking at PCA a little closer this weekend: trying to learn a little more about how this fits into portfolio construction.
I am not sure that weighting PC1 and PC2 according to the “variance they explain” is not a good (and very simple) idea for keeping your returns high while reducing your exposure to “market beta.”
A market-neutral portfolio could be constructed and that would be just an extension of this wouldn’t it? None of this is new or unused or even not-previously-discussed In the forum.
A lot of people In the forum hedge and use short positions. A lot of professionals hedge or use short positions using the concept of beta, Black-Scholes formulas for options etc. Not a single new or radical thing here!
I think we just keep ALMOST rediscovering what is done in finance all the time here in the forum. And at the end of the day decide to be “unredeemable luddites” as de Prado has called us (maybe a joke by him, I can hope).
For sure using PCA to weight your portfolio is a little more well-reasoned that just adding bonds in a 60/40 or 85/15 ratio. At least with the ETFs included in the above example, PCA takes into account the weights of XLP, XLU, GLD etc in creating the “risk-off” portion of the portfolio.
To reiterate PC2 is completely uncorrelated or “orthogonal” if you want to pretend (like me) that you really understand this. Actually, if unlike my wife and daughter you can visualize Cartesian coordinates-my daughter is great at statistics but some people simply cannot visualize it—“orthogonal” is not so complex. Sadly, I have trouble visualizing more than 100 dimensions Actually meant to say we all struggle with this as part of our human nature.
The PCA analysis above does not overweight bonds too much (less than 60/40 for sure) although one could reasonably ask whether bonds belong in a portfolio at all.
I would argue that the question of whether bonds belong in a portfolio goes away if you leverage the bonds up to the same expected returns (expected value) as equities. Then the question just becomes how much and whether you want to try to time that.
Anyway, nice (both of you)!
BTW, I get that I am still not up to speed with Korr123 on this and my points are probably “orthogonal” to what he is trying to express. In that regard this may have nothing to do with what he is trying to accomplish and is not a direct comment on any of that. That having been said, Rich’s and Yuval’s points can be useful, I think.
Jim