On February 2nd 2015 I launched this index with funds in the PRI account at Charles Schwab and notified three trusted leaders in the industry of the following: I will test the efficacy of this index with my own money and post the results on my blog. I am purposefully starting at a very high level in the market to provide a public record of this research project. The Sortino-Index has five colored triangles that either point up, down or sideways.
Initial Sortino-Index code was: BLUE (take profits and decrease equity exposure).
Portfolio Navigation begins by plotting a course to a financial destination based on an original discount rate (ODR) that discounts the future payout to the present value of the assets. In this case I chose an ODR of 8%, which seems to be a popular choice for most DB plans and was often used in my past research.
Next I will consider the weather conditions on this flight path. The near term forecast looks bad (see previous postings on this blog for market outlook). The world is in a mess, congress and the president are at each other’s throats, and yet, the stock market is at an all time high. We may well be heading into a financial storm front. This is similar to the problem discussed in the current issue of Pensions and Investments magazine (Feb 23rd), “Corporations weigh derisking vs. re-risking.” Graph 1 below presents the Portfolio Navigation solution to this issue. As navigator, I will investigate an alternate heading of 6% that might provide a reasonable chance of getting back on the 8% ODR course in a year or so.
The blue curves in Graph 2 below represent the distribution of returns for the totally passive PRI portfolio on the Charles Schwab platform that replicates the Sortino-Index. The black probability curves represent a combination of active and passive managers which, by my calculations, are superior to the totally passive distributions for both the ODR and AH cases. However, I do not want to confuse the active vs passive debate with the efficacy of portfolio navigation. Therefore, this research project will focus only on the passive portfolio. The Alternate Heading 6% distribution shown in graph 2 not only has a mean ( i.e. expected return) of 8.7%, it has the potential to earn 3% more than the AH of 6% (i.e., the upside potential is 3% + 6% = 9%).
Comparing this with the 8% ODR graph (not shown) indicates I am not being compensated for taking additional risk. Therefore, I chose to make the initial investment in accordance with the 6% AH. The performance results for the first month are shown below in Graph 3 and indicate we are above the 8% ODR course at this time with 50% less equity exposure than the 60/40 mix shown in the color code index at the top of this posting. It is important to note that the PRI optimizer does not just minimize the risk of falling below 6%, as derisking would. It maximizes the potential to exceed 6% relative to the risk of falling below 6%.
I believe performance should be measured relative to where you are on the path toward your goal, not relative to the S&P index or any other index. The goal is a specified payout. The investment objective is what you have to achieve in term of a risk-return trade off in order to accomplish your goal. Ergo, the investment objective for PRI is to maximize the potential to exceed 8% relative to the risk of falling below 8%. Graph 4 is an illustration of how performance should be presented. The star would represent the PRI portfolio’s current location. As Dr. Merton said in his HBR article (see previous Crisis posting), you need to know how you are progressing toward the pay out. If you are on or above the line, that’s good. You are fully funded.
Blog-Sortino Navigation Index-1st monthly performance report