Advanced Portfolio Management

Chapter 6Use Effective Heuristics for Alpha Sizing

• What will you learn here: How to transform single-stock investment theses into positions that result in the highest risk-adjusted performance. And how to set the size of your portfolio under changing market conditions.
• Why do you need it: Your goal is to be as profitable as possible while being resilient in any market condition. This chapter helps you be more profitable; the following ones help you become resilient.
• When will you need this: On a daily basis.

Ed Thorp and Jim Simons are considered the most accomplished quantitative investors alive. Thorp has authored an autobiography, “A Man for all Markets”, while Simons is the subject of the similarly titled biography “The Man Who Solved The Market”.¹ These books don't reveal many details about the investment processes devised by these two managers, but you can read a message between the lines. “Alpha” – broadly defined as the buy and sell signals – was not sufficient to generate outsized returns, especially in equities. Renaissance Technology (Simon's firm) had identified alpha signals, but it took years until these would produce sizable revenues. It was only in the new millennium that its Sharpe Ratio went from an already-good 2 to an outstanding 6 and higher. What made this qualitative jump possible was portfolio construction. Portfolio construction is a process that takes many inputs and generates a single output. The inputs are stock expected returns, transaction ...