CONQUERING

THE SEVEN FACES OF RISK

Automated Momentum Strategies that Avoid Bear Markets Empower Fearless Retirement Planning

This book intends to shake the very foundation of the sleepy momentum monoculture that seems happily mired in decades-old simplistic models that not only fail to treat momentum as the multi-faceted problem it is, but also fail to consider fundamental signal processing methods (older than Modern Portfolio Theory) that reduce the random walk part of the signal and improve the probability of making a better investment choice. The good news is two-fold: (1) The book’s principles and methods are described in a manner most ordinary investors will easily grasp, and (2) While it is truly complicated under the hood (like my car), software tools make it easy to drive. So, buckle up, turn the page, and let’s go for a ride!

Scott M. Juds

CONQUERING THE SEVEN FACES OF RISK

Copyright © 2017, 2018 Scott M. Juds

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Disclaimer: While we have tried to provide accurate and timely information and have relied on sources we believe to be reliable, the book may include inadvertent technical or factual inaccuracies. We do not warrant the accuracy or completeness of the materials provided, either expressly or implied, and expressly disclaim any warranties or fitness for any particular purpose. Nothing contained in this book should be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security, and is not intended as personal financial advice. Some of the strategies and portfolios presented in this book may not be suitable for your specific life plan and situation. The author is not a registered investment advisor and does not provide professional financial investment advice specific to your life situation. Performance information presented herein is hypothetical, is based on historical data and algorithmic models, and is not a guarantee of future results. That said, applying Temporal Portfolio Theory to level the playing field with Wall Street and tip the odds in your favor is what this book is all about.

ISBN-13:978-1543913750

Published by FinTech Press (www.FinTechPres.pub)  Rev. 05-2018

Originally Printed in the USA by BookBaby (www.BookBaby.com)

Table of Contents

THANKS

THE POINT

INTRODUCTION

PART 1: INVESTMENT RISK MANAGEMENT

CHAPTER 1: RISK MANAGEMENT PROBLEM OVERVIEW

◆ Identifying the Seven Faces of Risk

◆ The Retirement Savings Shortfall Crisis

◆ Can Someone Please Help Me Invest?

◆ Why A Holistic Approach to Risk is Needed

CHAPTER 2: THE HISTORY OF RISK MANAGEMENT

◆ The Definition of Risk

◆ Modern Portfolio Theory – 1952

◆ Hindsight and the Efficient Frontier

◆ Behavioral Economics – The Downside

◆ Measure Risk? Which Part?

CHAPTER 3: DETAILING THE SEVEN FACES OF RISK

◆ Risk #1 – Single-Stock Risk

◆ Risk #2 – Market Volatility

◆ Risk #3 – Bear Market Crash

◆ Risk #4 – Momentum Loss

◆ Risk #5 – Backtesting Deception

◆ Risk #6 – Strategy Hired/Fired Late

◆ Risk #7 – Savings Will Not Be Enough

PART 2: NEW TOOLS CHANGE OLD RULES

CHAPTER 4: RELATIVE RISK – A CONSENSUS STANDARD

◆ A Better Risk Measurement Standard is Needed

◆ Consensus Risk-Category Portfolios

◆ Relative Risk – Stable and Intuitive

◆ Measuring the Risk-Category Portfolios

◆ Single Fund Risk Misperception

◆ How Stocks, Funds, and Robos Stack Up

CHAPTER 5: TEMPORAL PORTFOLIO THEORY

◆ Momentum in Market Data

◆ Causes of Momentum – Will it Persist?

◆ Information Theory: Signal-to-Noise Ratio

◆ Differential Signal Processing

◆ True Sector Rotation

◆ Matched Filter Theory

◆ Automated Polymorphic Momentum

◆ Forward-Walk Progressive Tuning

◆ StormGuard-Armor: Market Safety Indicator

◆ Integrated Bear Market Strategies

◆ Portfolio of Divergent Strategies

◆ Crowd-Sourced Strategy Evolution

◆ Stocks vs. Sectors & Asset Classes

PART 3: FEARLESS INVESTING MADE EASY

CHAPTER 6: CONQUERING THE SEVEN FACES OF RISK

◆ Risk #1 – Single-Stock Risk

◆ Risk #2 – Market Volatility

◆ Risk #3 – Bear Market Crash

◆ Risk #4 – Loss of Momentum

◆ Risk #5 – Backtesting Deception

◆ Risk #6 – Strategy Hired/Fired Late

◆ Risk #7 – Savings Will Not Be Enough

CHAPTER 7: CREATING YOUR OWN 401K STRATEGY

◆ 401k Strategy Design Principles

◆ How to Build a 401k Strategy

◆ Two Example Strategies

CHAPTER 8: PRUDENT MOMENTUM PORTFOLIOS

◆ Overview of the Portfolios

◆ Prudent Momentum 20:80 – Fixed Income

◆ Prudent Momentum 40:60 – Conservative

◆ Prudent Momentum 60:40 – Moderate

◆ Prudent Momentum 80:20 – Growth

◆ Prudent Momentum 100:0 – Aggressive

SUMMARY AND CONCLUSION

APPENDICES

APPENDIX A THE DEFINITION OF RISK

APPENDIX B HOW MUCH RISK / DIVERSIFICATION

APPENDIX C TYPICAL MARKET CRASH PREDICTIONS

APPENDIX D RECESSIONARY THREATS

APPENDIX E INDUSTRY RISK-CATEGORY PORTFOLIOS

APPENDIX F RELATIVE RISK VS RISK NUMBER

APPENDIX G ROBO ADVISOR AND AAII PORTFOLIOS

APPENDIX H MARKET DIRECTION INDICATOR EFFICACY TEST

APPENDIX I FIDELITY GENERAL MUTUAL FUNDS LIST

APPENDIX J FIDELITY SECTORS MUTUAL FUNDS LIST

APPENDIX K ETFS PRE-2007 FUNDS LIST

APPENDIX L STRATEGY EVALUATION TOOL

APPENDIX M NAAIM 2016 WAGNER AWARD

APPENDIX N EXTENDED HISTORY TICKER SYMBOLS

APPENDIX O INTEGRATED BEAR MARKET STRATEGY EXAMPLES

APPENDIX P EIGHT FIDELITY ASSET CLASS STRATEGIES

APPENDIX Q ETF PRUDENCE PORTFOLIO CHARTS

APPENDIX R THE INEFFICIENT FRONTIER BY DECADE

APPENDIX S SUBSTITUTING MUTUAL FUND SYMBOLS

APPENDIX T PRUDENT MOMENTUM UNDERLYING STRATEGIES

BIBLIOGRAPHY AND REFERENCES

ABOUT THE AUTHOR

MORE PRAISE FOR THIS BOOK

Thanks

"I can no other ANSWER make but thanks,

and thanks, and ever thanks…"

– William Shakespeare

I would particularly like to thank and acknowledge my father, Donald Juds, a consummate mechanical engineer and businessman, for his early enthusiastic support during the embryonic DOS days of development when this looked promising, but was still comparatively simplistic and lame. I am also very lucky and thankful to have had two long-term friends, Jim Gamache and Mimi Berger, who believed enough to join me in forming a company in 2009 and work endless hours to convert some pretty good desktop software into a superb online-delivered service others could use to improve their retirement investment performance. I would particularly like to thank my brother, Mark Juds, a highly respected Principal Engineer of Eaton Corporation, and Joe Gruender of San Jose, for being such incredible SectorSurfer evangelists. I am also very thankful for the support, advice, and help of software engineer Stephen Gower, company advisors Jan Hendrickson and Ed Hubbard, AlphaDroid business partner Brian Sullivan, and tech support partner Gary Millhollen. This book was a mammoth undertaking that particularly could not have been possible without the support of my loving wife, Erin, and the amazing support of these fine people who thoughtfully spent countless hours reviewing drafts and providing feedback: Les Mosier, Stewart Wilson, Bruce Arnheim, Pat McCarroll, Charlie Enz, David Yeh, Raymond Rondeau, Richard Erkes, Kevin Cross, Harland Hendrickson, R. Buck Gray, Warren Hyland, Mary Ann Rini, Mark Juds, Ed Hubbard, Mimi Berger, and Jim Gamache.

Thanks for your help in making this book possible!

The Point

"Insanity is doing the same thing over and

over and expecting a different result."

– Unknown Butcrazytrue

Status Quo: Disappointing

If the future is anything like the past 3 decades, Modern Portfolio Theory’s⁸ (MPT’s) diversify and rebalance will disappoint again, neither excelling to the upside nor materially protecting the downside. Retiring early and well has become just another shattered fantasy for most. This book will change that!

Still, it’s important to remember that MPT was a giant leap forward in 1952 when Harry Markowitz realized that stocks analysis of the day didn’t include an analysis of the impact of risk on pricing. Establishing the connection between risk and return in a static (buy-and-hold) portfolio was a profound improvement and revolutionized portfolio management practices.

However, MPT was developed long before computers were available for generating daily market statistics. Thus, MPT was inherently limited to long-term statistical analysis of portfolios and market data. With no daily analysis capability, there could be no trend/momentum analysis. MPT models were limited to static buy-and-hold diversification. Design of a well-diversified portfolio requires determining long-term correlations between its constituent assets, then allocation-weighting them in a manner that minimizes standard deviation of the portfolio. This hindsight design practice is sewn into the very fabric of MPT and makes its portfolios blatant examples of curve fitting.t10

How has that worked out? The market crash of 2008-2009 was particularly dreadful. Asset classes chosen because they were poorly correlated, aligned and crashed together, resulting in MPT’s failure to provide meaningful downside protection. Regardless of the root cause of the crash, the minimum takeaway should be having an expectation that MPT will perform similarly in the future. Fiduciary prudence does not include standing pat for another roll of the dice.

You Can Change the Game

To achieve a different result requires a different approach. Academics, institutions, and individuals have long studied the market in hopes of finding an active management approach superior to buy-and-hold diversification. Among them, price momentum has long been shown¹,²,⁴ to be the best predictor of future returns in both academic and industry studies. Even Nobel Laureate Eugene Fama, the developer of Efficient Market Hypothesis (EMH) (random walk prices), has confirmed³ that returns associated with…momentum are pervasive and are the premier market anomaly that’s above suspicion.

Knowing that there’s gold in them thar hills isn’t sufficient – it must also be extracted. Fortunately, algorithms from the cross-disciplinary field of electronic signal processing (think Internet and cell phones) have also evolved and can be employed to extract trend signals from noisy market data to improve the probability of making an excellent investment decision. By owning only the trend leader and avoiding the trend laggards one can simultaneously improve returns and reduce risk. New tools change old rules. Although it seems contrary to the well-known MPT tenet that one must exchange risk for return, it’s made possible because it’s no longer bound by MPT’s framework – we now have a momentum trading method that incorporates a stream of new data.

And Put Safety First

In Behavioral Economics, Kahneman and Tversky’s "Prospect Theory"⁹ showed that investment risk is about the probability of actually losing money (not about standard deviation) and that the feeling of losing a dollar is much stronger than that of earning a dollar. This should be a wakeup call to get our priorities straight. When risk reduction becomes the forethought in design, it quickly becomes obvious that: Risk is not a one-dimensional problem cured by a single dose of diversification. Risk has many faces, each requiring its own remedy, many of which actually boost return through loss avoidance.

The Point Is…

Although MPT has been a disappointment, you can change the game – new tools change old rules! We’ll show you how easy it is to Conquer the Seven Faces of Risk. You don’t need a PhD for this any more than you need one to use a smartphone. Skim the highlights in the technical sections if you like, then push the easy button and skip ahead to Part 3 of the book.

Introduction

Necessity is the mother of invention.

– Unknown

One time-proven stereotype of engineers is that they will likely first break off the knob before reading the instruction manual for a new piece of equipment. But the problem doesn’t stop there. The engineer also feels compelled to fix the knob before proceeding. It’s what they do. To me, there’s nothing strange about that. It’s precisely what spawned the development of SectorSurfer, AlphaDroid, and finally, this book.

Since failure drives necessity, and necessity drives innovation, one might ask: What is the root cause of the failure that caused the necessity? Although financial sufficiency during retirement years is one of the most important things to get right in life, there were no Retirement Investment classes offered in high school or in either of the two universities I attended. Planning 40 years into the future apparently isn’t as important as getting a job to support a family on an entry level salary. We’re left to figure out investing for ourselves – while attending the School of Hard Knocks. And, that leads me to the backstory….

In 1980, the small electro-optics company I worked for had no 401k plan and its profit-sharing plan, although interesting sounding, had no profits to share during my first 3 years of employment. In fact, because many felt it was counterproductive as a company benefit for either attracting or holding employees, some young, rogue, unnamed engineer who was newly being included in middle management, led a campaign to terminate the plan. In hindsight, it is likely that insufficient patience resulted in cutting off potential upside even though there never was a financial downside.

I eventually started my personal investment efforts in 1983 when I received a bonus check for $3,900. While it was burning a hole in my pocket, I resolved that it was high time that I start investing in something – but what? The business section of the newspaper seemed superficial, and of course, there was no Internet. So, off I went to the Seattle Public Library to research the problem and hopefully ensure a wise decision.

After reviewing numerous newsletters and piles of highly detailed Value Line stock analysis reports, I concluded that the field of possibilities must first be narrowed – and to me, that meant I had to decide what was going to be the next big thing. I quickly (naively) dismissed electronics and computers as already having had their great runs, thus leaving little chance for continued outperformance. However, emerging biotech companies were kicking butt and clearly had only scratched the surface. I quickly identified the three best performing/trending companies over the prior year: Amgen, Genentech, and Monoclonal Antibodies (later merged into Quidel), and opened a Merrill Lynch account. I stood proud of my astute investment process and decision.

I soon found myself obsessed with tracking them at least a few times a week. After about 6 months they seemed to be doing reasonably well – two were up a bit and the third was sinking a bit. Then one Sunday I took a cross-country flight to Atlanta for a business conference and couldn’t check their prices until late Wednesday. I was flabbergasted to find Monoclonal Antibodies had fallen from $24.00 per share to a paltry $2.40 per share in the space of 2 days. A primary patent of Monoclonal Antibodies had apparently been successfully invalidated by an adversarial heavy-weight drug company, which in turn crushed the company’s valuation. I immediately knew I had just completed my first investment course in the School of Hard Knocks.

Something had to change – I couldn’t possibly monitor the news for such events coming out of left field while holding a full-time professional job. Furthermore, the meaning of single-stock risk became clear and needed a solution. It seemed obvious that mutual funds were the answer. Not only do they inherently eliminate single-stock risk through broad diversification, but they are managed by full-time professionals who can look out for and handle such problems. Henceforth, it would be professionally managed mutual funds for me!

It wasn’t long before I found a copy of the annual Money Magazine listing of mutual funds and selecting a pair of the better performing funds seemed the obvious, smart, and responsible thing to do. Certainly, the mutual fund managers who proved their skills over the prior year or so were the guys to bet on for the coming year…a skilled craftsman is just not going to lose his skills, tools, and supply of good information very quickly. I selected the two best looking ones and split the value of the remaining biotech stocks between them. I could now confidently go on with life knowing I had nailed my retirement savings responsibility. Like clockwork, I added another $2,000 to