Protective Asset Allocation (PAA) is a term popularized by Wouter J. Keller, a professor at Vrije University in Amsterdam. PAA, leverages a tactical asset allocation strategy focusing on price momentum and breadth momentum. The idea is simple; if the price trend is on an upward trajectory, chances are, it's going to maintain that course, and the same goes for a downward trend. However, there's more to the PAA model than you might think. It's based on a rather complex theory. To understand why it often works, we first need to learn a bit about macroeconomics.
It works on the presumption that asset prices have a certain momentum effect. If an asset's price starts going higher, it's more likely to continue along that trajectory in the long haul.
Let's consider the stock market, it comes with an innate capability to act as a hedge against inflation. And why is that? Well, as we're all aware, it's the government that's in charge of printing money. Central banks are the official entities, acting on behalf of the government, tasked with managing money-printing mechanism to control the nation's monetary policy. The objective is to manage key factors such as inflation, job creation, and long-term interest rates.
The main aim of central banks is to ensure price stability by keeping inflation within a designated target range. Exorbitantly high or exceedingly low inflation can upset a nation's economic well-being. Central banks seek to stimulate employment and economic growth, especially in the face of recessions, by manipulating the money supply to manage interest rates. They also aim to guarantee the stability of the financial system and manage public debt. The process of money creation is an intricate affair demanding a finely balanced approach. An overflow of money into the economy can set off inflation and other economic quandaries, whereas an insufficient amount can result in economic stagnation and unemployment. This process of money creation and its repercussions on the economy correlate directly with asset prices. The slow depreciation in the value of money over time, courtesy of inflation, generally propels asset prices upward, even if the intrinsic value of the asset remains unchanged.
With this in mind, the first fundamental concept of PAA starts to make sense. Regardless of the circumstances, the government prints money, whether in larger or smaller amounts. The rate of printing typically fluctuates over lengthy time intervals, rendering a certain consistency to price changes. And this consistency paves the way for the phenomenon of long-term upward asset price increases. This simple insight underlies the investment strategies of the billionaire class, including the likes of Warren Buffet and Ray Dalio. They didn't amass their wealth by short-selling assets in the long term but by buying and holding onto them.
Breadth momentum is another key factor in PAA. But to fully comprehend this, we first need to define what momentum is. Price momentum refers to the rate of price increases, demonstrating the level of consistency in the asset price. We now understand that asset prices exhibit long-term consistency, and a PAA portfolio quantifies this level of momentum within specified time frames.
But PAA doesn't just focus on the momentum of one asset; it also considers the momentum across different asset classes. To put it simply, even if there's a price increase in the stock index of developing countries, we wouldn't invest there if there's a decreasing price momentum in the stock index of developed countries. This principle hinges on the correlation among assets.
In finance, assets are classified into two main categories, each with a distinct relationship to inflation that influences their risk and return characteristics.
Risky assets have the characteristic of hedging against inflation, and inflation affects the entire economy. As a result, most risky assets are influenced by inflation, and they display clear correlation. Determining when one risky asset is increasing while another is decreasing becomes crucial to avoid unexpected and undesirable situations. Breadth momentum is a tool that can address this concern.
The PAA method allocates its cash to risky assets and tracks the number of risky assets showing an increase in momentum level, as well as the number of risky assets showing a decrease in momentum level. Based on this information, it decides how much should be invested in safe assets and risky assets. In this way, it creates a balanced portfolio that can endure various economic circumstances while still offering opportunities for growth.
Even though the price of risky assets typically goes up over the long term, there can be periods when these assets' prices fall due to economic and market situations. A recession is a prime example of this, where consumer and business spending reduces, leading to a decline in the value of risky assets like stocks and commodities.
In such periods, demand for construction, products, and services decreases due to lower consumer spending. This, in turn, reduces the value of the commodities associated with these sectors, creating a domino effect throughout the economy.
In these challenging times, safe assets such as bonds can provide a much-needed hedge. Traditionally, bond prices tend to rise during recessionary periods, primarily due to a decrease in interest rates by the government. The interest rate drop is usually an effort to stimulate spending by consumers and businesses.
So, if you've invested in a bond with a higher interest rate before the drop, that bond now becomes more valuable compared to the currently issued bonds with lower interest rates. This rise in bond value can be an effective way to safeguard your investments during a market downturn. Additionally, it also presents an opportunity to potentially make money, or at least prevent losses from downtrending risky assets.
PAA's emphasis on breadth momentum and allocation between safe and risky assets takes into account these economic fluctuations and aims to provide consistent returns over time.
Understanding the Protective Asset Allocation (PAA) methodology and its connection to the fundamental mechanisms of the economy is an insightful journey. The strategy's simplicity, combined with its focus on core economic concepts, makes it a robust approach to asset allocation.
Now, as we transition into discussing the details of a cryptocurrency-specific PAA strategy, it's important to note that cryptocurrencies bring in additional considerations and dynamics. For instance, their relatively high volatility, market sentiment influence, regulatory implications, and technological advancements can all influence their price movements. Let's delve into how these factors interplay with the PAA methodology, and how we can tailor this strategy to effectively manage a cryptocurrency portfolio.
The choice of the timeframe to calculate momentum can significantly influence the results. In more volatile market situations, a shorter timeframe might seem appealing. It allows for faster reaction to price changes, providing the agility required in a rapidly moving market. However, a shorter timeframe also comes with the risk of reacting too quickly to temporary price corrections, possibly leading to selling off assets during an overall uptrend.
So, predicting market volatility becomes crucial. If one can accurately foresee market volatility, they could adjust their momentum calculation timeframe accordingly, potentially optimizing their investment strategy. But forecasting market volatility is no easy feat. Even experienced traders and algorithms struggle to consistently make accurate predictions.
Given the Protective Asset Allocation model's primary goal of capital protection, attempting to predict market volatility could add unnecessary risk. Instead, the PAA model is designed to adapt to the market conditions based on observed price trends. This doesn't mean ignoring market volatility but rather not betting on its predictions. It is about achieving a balance, a blend of agility to react to immediate market changes and the stability required for long-term investment growth.
So, the answer lies in using a multi-timeframe approach for calculating momentum. Each portfolio under the PAA model - Defensive, Progressive, Unlimited - incorporates smaller sub-portfolios, each utilizing different timeframes from 1 to 6 months. This ensures that we can cover a wide range of market scenarios without needing to predict precise market conditions.
This approach also tackles another common pitfall - overfitting. Overfitting happens when a model is excessively complex, capturing random noise instead of the underlying pattern. It's like driving a car while only looking at the rearview mirror - it might work for a while, but it's not reliable for long-term success.
The market, akin to a living creature, is unpredictable and ever-changing because it is essentially a reflection of human behavior. Betting everything on a single scenario under the assumption that past behavior will repeat exactly is a flawed approach. It's more effective to keep our options open to the possibility of diverse outcomes and adjust our bets accordingly.
PAA, with its emphasis on momentum, capitalizes on the inherent nature of assets to increase in price over time. Aiming for the highest return based on a specific anticipated market condition isn't the goal here. Instead, our strategy is to cover a broad spectrum of potential scenarios. We might not always hit the jackpot, but we're very likely to make steady gains over time.
The principle of breadth momentum works on the assumption that asset classes are correlated in some way. For instance, during prosperous economic times, risky assets like real estate, stocks, and commodities generally see increased demand. In contrast, during a recession, the demand for these assets falls drastically.
In the context of cryptocurrencies, Bitcoin and Ethereum have been selected for this model due to their strong historical performance and high correlation. They have a correlation coefficient of 81% based on Yahoo Finance historical data, suggesting that their prices tend to move together with an 81%' chance, assuming a linear relationship between their prices.
This correlation is vital for risk management - if a risky event impacts either of these assets, the model can promptly reduce or close our positions to safeguard against major losses.
However, some might wonder why we don't use altcoins for potentially higher returns. While altcoins can indeed yield significant profits in backtesting scenarios, applying these results to actual client portfolios is a different matter altogether.
Backtesting altcoins that have survived and yielded high returns isn't a guarantee of future performance. Predicting the future rise of any given altcoin is inherently uncertain, and there's no guarantee against potential fraud in this largely unregulated and unsupervised market. These risks - known as survivorship bias and credit risk - are critical considerations.
For this reason, we advise against using altcoins in client portfolios using the PAA model, despite their potential for higher returns in backtesting scenarios. The PAA model aims to ensure safety and reliability, which is why it opts for assets like Bitcoin and Ethereum that have proven their worth over time. Our priority is to minimize the risks associated with investing in cryptocurrencies, rather than chasing potentially higher yet uncertain returns.
Understanding the fundamental principles underlying the Protective Asset Allocation method is crucial. This strategy leverages the inherent characteristics of the economic landscape and the specifics of the cryptocurrency market. Understanding the nitty-gritty, such as the precise methods used to calculate momentum and volatility, can dive into deeper technicalities that might be too complex for most investors.
Much like constructing a house, while it's beneficial to understand the basic design and the materials being used, you don't necessarily need to know the intricate details of how each brick is laid or the exact diameter of the support pillars.
The original Protective Asset Allocation paper is available for anyone interested in delving into the detailed mechanics. However, for those who prefer to place their trust in a team of experts or don't have the time or expertise to implement these strategies independently, we're here to help.
Our aim is to use our knowledge and expertise to navigate the complexities of the cryptocurrency market on your behalf, ensuring your investments are handled professionally and diligently, always prioritizing the protection of your assets.