Hedging DARWIN Portfolio Risk with $DWC

18 July 2017
The Market Bull

In this blog post, we’ll discuss how DARWIN Investors can diversify away some of the excess risk posed to their portfolios by Loss Aversion, a common and well-researched phenomenon in behavioural finance.

In particular, we’ll discuss why it makes sense to include DARWIN $DWC in a portfolio that’s partially or entirely composed of loss averse DARWINS.


But first,

  1. A quick recap on what Loss Aversion is,
  2. Why even the most perfectly diversified portfolio of DARWINs can be susceptible to unforeseen shocks due to loss averse behaviour,
  3. What DARWIN Investors can do to hedge this risk.

Loss Aversion (Illustration)

Loss Aversion (Illustration)

Loss Aversion:

Simply put, traders are said to be loss averse when they hold on to losing trades for extended periods of time, but take quick profits on winning trades.

It yields two main outcomes:

  1. Returns growth looks fairly steady during periods of profitability, small profits smoothing the curve.
  2. Major drawdowns however, are disproportionately larger – sometimes leading to prior profits being wiped out by the closure of large losing trades that were being held on to for a long period of time.

 

Granted, a diversified portfolio of reasonably uncorrelated DARWINs has its advantages in terms of minimizing overall portfolio risk.

However, if it contains DARWINs with poor scores for the Loss Aversion attribute (La), it may still be susceptible to shocks during:

  1. Periods of market turbulence,
  2. Deep unforeseen movements,
  3. Unusually volatile news releases,
  4. Black swan events, etc.

.. where diversification benefit temporarily breaks down, owing in part to losing trade closures that distort the portfolio’s original risk profile.


What can DARWIN Investors do to protect themselves?

In one of our recent posts – $DWC – A Real Time Sentiment Index & Security – we highlighted the fact that DARWIN $DWC replicates the opposite of the Darwinex trader collective’s behaviour.

GBP Flash Crash (October, 2016)

GBP Flash Crash (October, 2016)

It typically rises during times when loss averse traders experience undiversifiable risk.

For example, $DWC profited from the GBP Flash Crash.

Undiversifiable risk also frequently presents itself when loss aversion eventually leads traders towards margin calls, causing sudden, unexpected volatility in the overlying DARWINs.

 

In such situations, portfolios that contain DARWIN $DWC can benefit from DWC hedging away a significant proportion (depending on position management of course) of undiversifiable risk experienced by investors.


When does it make sense to include $DWC in a portfolio?

  1. Investors can include $DWC in their portfolios to hedge against DARWINs with a Loss Aversion (La) score < 4.0 and Capacity (Cp) score > 5.0.
  2. Capacity (Cp) > 5.0 describes DARWINs that primarily trade long term movements. If such DARWINs also have a Loss Aversion (La) score < 4.0, the investor’s portfolio is likely exposed to undiversifiable risk at some point in the future.

    Low Loss Aversion Score

    Low Loss Aversion Score

  3. Check the Correlation of low La DARWINS against the $DWC – If they are negatively correlated, it becomes more likely that $DWC will offset excess risk should the loss averse DARWIN encounter  undiversifiable risk.

    Check Correlation of Loss Averse DARWIN Against DWC

    Check Correlation of Loss Averse DARWIN Against DWC


What composition of assets could well diversified DARWIN portfolios (hedged against loss aversion) contain?

Example Portfolio #1:

  1. 50% Short Term DARWINs (Capacity < 5.0)
  2. 25% Long Term DARWINs (Capacity >= 5.0)
  3. 25% allocation to $DWC as a hedge against loss aversion / undiversifiable risk.

Example Portfolio #2:

  1. 40% Short Term DARWINs (Capacity < 5.0)
  2. 30% Long Term DARWINs (Capacity >= 5.0)
  3. 30% allocation to $DWC as a hedge against loss aversion / undiversifiable risk.

Note: Investors should of course exercise their own discretion in selecting portfolio allocations. The examples above illustrate what such allocations could look like, accounting for multiple timing horizons whilst hedged to a reasonable degree against loss aversion.


Additional Resource: DARWIN Statistics – Correlation
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