There are different ways to choose how much to invest in each holding in a portfolio. Some investors choose equal weights, some choose to overweight assets with higher expected returns, and some choose to overweight assets with lower volatility.
Some use very complex mathematical models to determine the optimal weights, while others rely on gut feelings.
Investors use allocation strategies either to reduce risk and volatility in their portfolios (by assigning higher weights to “safer,” less volatile assets) or to maximize their returns (by overweighting stocks with higher expected or historical returns).
Scrab makes it easier to choose the optimal weights for your portfolio by providing four different strategies. Backtests allow you to test how different strategies impact returns and volatility.
Available Strategies
Equal Weights
The most basic strategy. Total available cash is distributed evenly across all assets.
Example: If you have $1000 and 5 assets, each asset will get $200.
Equal Risk
Each asset will carry the same amount of risk based on all assets’ historical price correlation and downside risk.
Based on the Risk Parity Portfolio Design approach described by Yiyong Feng and Daniel P. Palomar in 2015. Detailed description can be found here.
Considers 10 years of historical data.
Hierarchical Risk Parity
Asset weights are determined based on the Hierarchical Risk Parity algorithm proposed by Marcos López de Prado in 2016. Learn more here.
This sophisticated mathematical approach also considers 10 years of historical data.
Proportional to Metric
Weights are determined based on the current value of a chosen metric. Any metric available in Scrab can be used here.
If a given metric is not available for some assets, an average from other assets in the portfolio will be used, so the company with a missing metric won’t be penalized or rewarded.
Unlike in Equal Risk and Hierarchical Risk Parity, the difference between the biggest and smallest asset weight in the portfolio is limited to around 2.5x.
Additional Options:
a. Higher Values Preferred: If you choose this option, assets with higher values of the chosen metric will get higher weights. Example: To assign higher weights to companies with a bigger Market Cap, enable this option. Conversely, to assign higher weights to companies with a lower P/E ratio, disable this option.
b. Correlation Adjusted: If selected, companies with lower correlation with the rest of the portfolio will have bigger position sizes. Important: This only considers “downside correlation” from the past 10 years, meaning how often the prices of the assets decline at the same time. Investors typically fear simultaneous price declines more than simultaneous price increases.
Important Considerations
Equal Risk and Hierarchical Risk Parity can strongly overweight one asset or a relatively small group of assets, which may not be suitable for all investors.
These strategies are based on historical data and may not be optimal in the future.
By understanding and utilizing these allocation strategies, you can better manage your portfolios to align with your risk tolerance and investment goals.
Scrab’s tools provide a structured approach to optimize portfolio performance based on individual preferences and historical data.