The offensive component aims to maximize return while the defensive component aims to lower volatility and therefore portfolio risk.
As we know, volatility is a common measure of portfolio risk. Depending on the correlation of stocks we combine into a portfolio, we are able to lower the overall volatility of the portfolio.
However, depending on how you decide to size your positions, each position may contribute a different level of risk towards the overall portfolio.
Momentum is the concept that stocks which have shown strength in the past tend to show strength going forward. Academic research suggests that assets with the greatest relative performance over the past one month to one year are more likely to exhibit stronger performance over the next period.
This asset allocation strategy involves the following steps:
- Assets in the portfolio are first sorted by their returns over the past X months. Those assets that have delivered better than average returns will remain in the portfolio. In other words, those assets that fall within the top 50% by return.
- Next, the volatility of each asset over the past X months is calculated. This figure is used to adjust the allocations of the
above stocks such that each stock contributes the same daily volatility to the portfolio.
In essence, you are sizing each asset in the portfolio so that it is expected to contribute the same amount of (nominal) risk towards the portfolio.
The VWM is not a buy and hold strategy but is rather one that is intended for regular (eg: monthly) rebalancing.
For example, you might define a universe of 15 stocks and ETF's to run the VWM against. Based on the results you would rebalance and remove positions accordingly.
The following month, you would again run the original 15 stocks through the VWM algorithm to determine the new allocation.
The result is a rolling portfolio of the best performing stocks over the past X months coupled with a position sizing strategy which aims to equalize individual asset risk across the portfolio.
This article provided a brief overview of the Volatility Weighted Momentum strategy. For more information you can read the complete white paper here.
The asset allocation tool provided by Diversify Portfolio provides you with an implementation of the VWM to use with your stock portfolio. More information on the tool can be found here.
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