How Much Is Too Little Or Not Enough?
How Much Money Should You Allocate?
If this question is niggling at you, consider how risk-averse you are. That may give you the answer you're looking for.
Trying to figure out how much money you should allocate to your trading is a difficult task. How risk-aversive are you? To get the answer, I will look at the traditional stocks and bonds and a trend-following method applied to gold, EUR/USD, and the Standard & Poor's 500, covering different asset classes.
THE TRADING SYSTEM
I use point & figure for the signals, using 2% sized boxes and three-box reversals. Point & figure was the first method I learned 20 years ago and I have found it mimics the way most professional traders think if they are not using some other system.
Using this method on your own trading strategies, you can back-test how much you should allocate to your trading strategy and how much you should keep in other assets such as stocks and bonds.
THE MODEL
I use a quadratic risk-aversion function, which has the following form:
Where E[U(w)] is the expected utility of a portfolio where the w weights to different investments. E[w] is the expected return and E[w2] is the expected portfolio variance. The parameter b is a measure of risk aversion and tells you how much you value portfolio variance. A b of zero would mean that you only care about return and place no value on risk. A high value of b would mean that you are very risk-averse.
In Sweden, the population on average seems to be risk-averse where the value of b is equal to 2. Larger shareholders and wealthier people will have a b value lower than that -- in other words, they are more inclined to hold more stocks and fewer bonds.
I have used data from January 2000 to February 2007, a period in which a new investment paradigm may have been introduced. In this paradigm, it is not optimal to own any stocks, but it is to own commodities.
...Continued in the September issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the September 2007
issue of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright
2007, Technical Analysis, Inc.
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