Why The Portfolio Working Together Is Greater Than The Sum Of Your Portfolio's Individual Parts

Science and/or business may teach you the concept of synergy. If not, Synergy is when the WHOLE is GREATER than the sum of it's parts

What this means is that if you take a wooden 2 by 4 board and put say 100 pounds on it, it may reach it's breaking point. Now if you take two of these and bind them together, you might think that it would take 200 pounds to reach the breaking point. Not SO. Synergy is involved so that the support of two is greater than the support of the sum of each. In other words, the boards together may produce enough support to hold up to 300 pounds without breaking.

In trading terms, this does manifest itself in a way as well, but it's tricky to explain without first starting simple...

Say for example you have the option to either own a stock market ETF or cash and that is it. Assume NO FEES for trading. Assume a random walk. (over enough time it also works over a relatively normally distributed market that "cycles". This is not a "real market" but the market is "normally distributed" or at least very close. In other words, the market has a very good chance of having a near equal number of consecutive up days and down days over the life of it's trade to a near same magnitude. For example, take a look at Apple's stock courtesy of tastytrade's research. That may or may not mean that the market is a "random walk". I believe it cycles and it sometimes breaks into a trends up and breaks into a trend down. I believe there are things that only temporarily give it pause and it retraces, but ultimately throughout a cycle it is evenly distributed. In either case this chart should give you a look at what is "realistic" when it comes to trying to determine your odds of catching a trend. You may with skill be able to get an edge, but it won't be much.


As such, just for example purposes to generate "synergy" we will consider it a RANDOM market. Can you beat it? The answer is yes... with synergy (and no commission trades).

The solution in the hypothetical random market with only stocks and cash and no options MUST be that you hold 50% cash and 50% stock. If the stock doubles in price due to randomness, consider it a gift. If you have $1000 in cash and $1000 in stock, now you have $2000 in stock and $1000 in cash. "Rebalance" your portfolio, by selling HALF and now you have $1500 in cash and $1500 in stock. Now if the stock cuts in half back where it started, you have $750 in stock but $1500 in cash for a total of $2250. $250 more than you started.

We Could demonstrate why this works even if the stock oscillates and eventually ends up below where it started IF there was enough time and volatility, but the point is, that if you owned simply the stock, you would be back where you started and have only a 50% chance of a profit in ANY condition. You could do NOTHING else to beat this market as the long odds wipes everyone out who is GAMBLING. It is only with SYNERGY that you can create the balance that keeps your account growing as time goes on.

The real market would require that you wait for enough of an oscillation to where you can afford the fees once it "normalizes" but were this market entirely random and no fees, you would rebalance as often as possible. Since avoiding fees becomes so important, using a 30+day rebalancing period using commission free trades (which require at least 30 day hold before you can sell) is a great way to take advantage of this more frequently.


For this same reason, holding 25% stock ETF 25% commodity ETF 25% cash and 25% Bond ETF and maintaining that relationship every now and then will produce very good gains in the "real market".

EVEN if you do not reblanace, this strategy still catches the monetary expantion as it expands and goes SOMEWHERE. Even if there is some deflation your cash is worth more and can buy more. Over the long run this strategy works very well.

Now this is not meant to promote a permanent portfolio strategy of 25% of each, but instead to show the value of correlation. Take for example a look at what we call the correlation matrix of this portfolio with...
EEM(stocks) GLD(gold) TLT(bonds) and UUP (cash)


 

The average correlation of the assets is -.085 over the last 6 months, AND if you sum the individual correlations divided by the number of asset pairs and then sum up. Add in USO (oil) and you currently get the correlation to under 1%.

We will discuss correlation more in the future. For now just understand that a negative 1 correlation means as one goes up the other always goes down and that a correlation of 1 means as 1 goes up the other goes up. A zero correlation means that basically as one goes up, the other either goes down 50% of the time and up 50% of the time or stays the same. Thus a zero correlation means each bet is "independent" and will offer plenty of opportunity to gain on it's own. A zero or negative correlation strategy works well because the probability of all assets declining at the same time are very slim if the past corelation holds into the future. In other words, you very often have an area which to both add to and reduce from to rebalance and maintain the allocation balance required to profit using that strategy.