The second aspect of the work that is presented here is the choice of the rule under which timely changes in the allocations of account equity are decided upon.
The most important understanding that we can have, if we are to fully benefit from quantitative analysis of the trailing history of the markets, is that having a “theory” as to why a particular rule is better than another is hardly necessary. It’s necessary to confirm that an inefficiency exists; the cause need not be known. Empiricism is the appropriate ultimate resort and we should not consider a priori assumptions about human behavior in the marketplace to be trustworthy.
For example, many academicians admit that momentum works, that to some extent advances in stock prices tend to be followed by continued gains. But they call it an anomaly because it doesn’t fit into the theoretical concept of an efficient marketplace. It’s because momentum works that it is one of the programs presented here, not because there is some good reason to believe that stocks that are going up in price should continue to go up in price.
Presently all of the rules for making changes in allocations of account equity that are in use within the Traded Portfolio project incorporate what is usually called a “walk-forward” procedure— one or more parameters that affect the allocations are determined on the fly, based on the trailing history. In that way we stand a chance of the program proving to be adaptive to changes in the way that the market trades and we may be afforded a major advantage over the more static approaches.
Presently the rules whose outcomes are presented in these pages— they are momentum-based at present but there will be other schemes— are based on dividend-adjusted price histories. However, nothing about the basic structure or design of the programs in use imposes a limitation to the use of price data and indeed factors not directly involving price such as value, market capitalization or industry-group classification are taken into consideration as selection criteria for candidate securities lists out of which portfolios are formed.