We can use leverage or restrict volatility

  • We can also introduce leverage, as a fixed or variable percentage of the capital invested, without significantly altering the return per unit of risk (a.k.a. the Sharpe ratio).
  • Leverage will increase the returns when the model goes up and increase the losses when the model goes down. And there will always be periods when the model goes down, however much we would like it not to.
  • We can also design models which target a pre-agreed (i.e. low) level of volatility. We normally do this by introducing a fixed or variable amount of cash into the portfolio, but we can also restrict the exposure to high risk assets.
  • We prefer the first method because there should be minimal impact on the Sharpe ratio, but the process is very flexible and can accommodate all sorts of investor preferences.