My application of an asset allocation scheme is certainly not new. What was new for me was thinking about asset allocation in a different way. This allowed me to understand why asset allocation can be useful and specifically, why it I should incorporate it into my trading system. Previously, when I thought about trend following systems, I thought in terms of individual markets. Starting with a basket of assets (let us use stocks as an example) that meet criteria for price, volatility, and volume, a trend following system produces a signal to go long or short. A position sizing and portfolio risk management system is invoked that accounts for volatility and correlation. This view treats the basket of stocks as individual entities. We can think of this by equating the basket of stocks to a set and each stock as an element of the set.
An asset allocation approach has a different view. The basket of stocks that meet our criteria is still considered a set. However, the elements of this set are now asset classes, not individual stocks, thus we have a family of sets. An individual stock is a member of a particular subset of the set of the stock basket, thus it is a member of an asset class. The family of sets are disjoint, meaning that asset classes do not have stocks in common. This may appear to be an odd way of thinking about asset allocation, but I have been brushing up on set theory for the past month for my job and for me it clarifies the concept.
Once I decided to use asset allocation, the next step was to develop asset classes. After reading about a number of different ideas, is settled upon the following 6 asset classes:
- US stocks
- US treasury bonds
- International stocks
- US real estate
Implementing this approach consists of committing an equal dollar amount to each asset class. I will show the details of this when I post how I constructed my portfolio.