MLR - MDM bet size / risk example
The MDM is staying on buy for now for the reason we wrote in this morning's PMP: When comparing the current sell-off to prior sell-offs in 2013, the market is at a point that has previously been the juncture at which the market finds its footing due to effects from quantitative easing, thus the Market Direction Model has remained on a buy. That said, should selling pressure increase in the days ahead, the MDM will account for this and act accordingly.
Each member has their own risk tolerance levels. Should a signal move past one's maximum % loss point, one should always sell. Thus, some members opt for 1x or 2x ETFs since they realize that 3x ETF will more than likely exceed their maximum % loss point.
2011-present have been relatively trendless. MDM was able to well outperform the major averages in 2011 due to catching the very few good trends, sometimes more on the shorter term side. 2012 to present has been met with lackluster market action which causes repetitive nicks, cuts, and bruises. That said, new trends start often when least expected. In July 2011, a number of investors quit the market, then from August, MDM returned 5 highly profitable signals in a row. This is show here: http://www.virtueofselfishinvesting.com/results. So it is important to keep an eye on markets. It is also entirely prudent to risk less funds when challenging times arise, then increase your size with increasing wins. For example, on a false signal given by either model, one could reduce next size by x%.
Risk Size ... Win(W) or Loss(L)?
100 ... L
Next bet size:
(100-L)*90% (This means one takes new starting capital which includes the loss and only invests 90% of the total).
So if loss was 5%:
(100-5)*90% = 85.5 new bet size
Bet Size ... Win(W) or Loss(L)?
85.5 ... W
Next bet size:
(85.5+W)*110% (This means one takes new starting capital which includes the win and investors 110% of the total).
So if win was 10%:
(85.5+10)*110% = 105.05
And so on.
One could create a maximum bet sizes so even if MDM gets a string of true signals, their bet size does not exceed this maximum.
In the accounts we manage for clients using the MDM we have taken into account 1) a lack of upside cushion so far in 2013 and 2) the state of the market's internals in making decisions with respect to avoiding altogether volatile buy signals such as we saw recently as the market gapped up to higher-highs or taking much smaller positions in order to limit risk. The upside is that we can limit losses on a signal that does not immediately produce movement in the desired direction, but of course this has also hurt us when we did not take a signal that proved profitable. Each investor must determine for themselves the course of action they will take based on their profit cushions and risk-tolerance in any particular situation.
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