I concentrate a lot of my efforts in portfolio management in determining the right level of leverage for my risk / return goals in prevailing market conditions as I think a lot of value can be found in this area – especially in combination with the diversification benefits of asset allocation and strategy selection.

**The Outside View**

Rather than trying to calculate expected risk and return from all the individual portfolio elements and their correlation, I like to take the opposite approach first and take the outside view, looking at the examples of other investors and market studies to find a realistic benchmark. From that I estimate what results my approach might bring. I try to analyze my own risk tolerance visualizing my past investing experiences, especially the large drawdowns. I then build in a margin of error to be more realistic and decide on my portfolio exposure from there.

**Sharpe Ratio**

I concentrate on the Sharpe ratio as a measure of risk-adjusted return even though it has some limitations. It is the most widely used measure, which allows comparison of a variety of different studies to each other. Absolute return numbers alone are quite useless, as they don´t give any indication of the risk taken to achieve them.

The Sharpe ratio is the excess return (above the risk free rate) divided by the volatility of returns (as a proxy for risk).

When looking at the risk-adjusted returns of different asset classes over a long period of time their Sharpe ratios cluster around 0,3 – they all basically have the same risk-adjusted return expectation over time.

Financial markets are fairly risk efficient overall, because investors constantly seek to find pockets of excess return for a given level of risk and thereby bring it back down to a common mean.

**The upper ceiling of possible returns**

- Star investors like Warren Buffet, George Soros, Paul Icahn and others have managed to earn 20% – 30% yearly returns over a span of decades boasting Sharpe ratios between 0,7 and 1. This implies a very high risk tolerance, as drawdowns frequently top -50% for such return distributions.
- The best long term hedge fund returns I came across are James Simons´s Renaissance Technology´s Medallion fund at 35% annual return over decades and Edward Thorp´s Princeton Newport Partners averaging 20% annually with a minute 6% standard deviation and an incredible Sharpe Ratio of 2,33 (the highest I ever came across spanning decades) – this was achieved using leverage around 8 times in a completely hedged statistical arbitrage portfolio.
- A very interesting example of concentrated value investing during very bad times is John Maynard Keynes investment management of the Chest Fund, King’s College, Cambridge, during the great depression, 1927-1945. Beating the market considerably, he made 9% per year with a Sharpe ratio of 0,4.

**The realistic average of the market including timing and strategies**

- The classic portfolio mix of 60/40 stocks and bonds historically had an annual return of 8,5% and a Sharpe ratio of 0,4-0,5.
- Different buy and hold Global Asset Allocation methodologies including smart beta factors had 9,5% to 12% annual return and historical Sharpe ratios around 0,8. The return dispersion of different allocations over long time frames has been astonishingly small.
- Global Asset Allocation including market timing (moving average trend following) boosts Sharpe ratios to 1-1,1 by reducing drawdowns.
- Trend-following Managed Futures strategies have achieved long-term Sharpe ratios between 0,6 and 1 and are able to target specific volatility levels very well.
- Historical Sharpe ratios for Volatility Selling vary more widely because strategies differ considerably. Examples are PUT index 0,7; S&P systematic strangle portfolio 1,53 or Vix strategies 0,85 – 1,3 (biased towards overestimation because of negative skew).
- A reality check back with the actual historical return of professional money managers shows that a Sharpe ratio of 1 has been a long term ceiling for virtually all of them.

**combining different strategies could land a portfolio´s long-term Sharpe ratio at 0,7 – 1 at a maximum. That is the goal I set for my portfolio.**

**Setting benchmark expectations**

**historically a fully invested diversified portfolio (mixing the strategies above) would have returned between 11% to 15% annually with a standard deviation between 8% and 12%**depending on weighting and exact rules. The Sharpe ratio historically had a fairly stable value around 1, as higher returns coincide with higher volatility. The maximum drawdown since 1973 was approximately -20% to -25%. The reality check above leads me to pull these estimates down a bit and anticipate higher volatility and drawdowns.

**Let´s set a basic benchmark and expect 10% annual return with 12% volatility (a Sharpe ratio of 0,8) for our unleveraged portfolio of global asset classes and strategies.**Current 10-year estimates from virtually all market experts are quite a bit lower than historic averages for the major asset classes, due to the high valuation of stocks and bonds. To realize our benchmark going forward, we may have to rely heavily on global diversification, real assets and alternative strategies, looking very different from a traditional 60/40 portfolio.

**Using Leverage**

As option selling strategies and futures allow the efficient use of low-cost leverage for individual investors in a margin account, I look at optimizing the benchmark exposure for my personal goals and risk tolerance. This is a very personal process and it would not be a good idea to simply copy it.

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