Asset Price Trend Theory: Reframing Portfolio Theory from the Ground Up

Abstract

Traditional portfolio optimization models specify placement of capital as rather irrevocably and fully at risk through investment horizon(s) or continuously. Under this constraint, asset class allocation typically serves as primary mode of diversification, pursuing risk moderation by seeking to reduce portfolio variance. But investors adopting this construct find that risk management inevitably fails to encompass risk containment to limit negative variance, leaving drawdown risk unbounded to a fully 100% loss. Here the author turns to the little-discussed yet universally held and most basic of assumptions in finance—that asset prices tend to trend—and considers the implications of constructs reframed in a consistent and corresponding manner. Most important is enabling the pursuit of risk containment that, through stop-loss protocols (i.e., loss-contingent exits), seeks to limit negative variance, to limit drawdown depth. Additionally, with risk containment centered on exit protocols, the pursuit of growth can proceed in a relatively unconflicted form via traditional modes of capital deployment and via now logically enabled price and return-trendcontingent alternatives. Within a more broadly applicable capital allocation framework, the author illustrates how the pursuit of risk moderation, such as through traditional asset allocation regimes, is logically and operationally subordinated to the objectively more pressing and critical matter of risk containment. <b>TOPICS:</b>Portfolio construction, risk management, statistical methods