The "Universal Portfolio" Perfect Investing System - Mike Swanson (12/28/2014)

What are you working on in 2015?

What are your goals for next year when it comes to your investing and trading?

Every year I take a break right now and look over the market and try to figure out to the best of my ability what the big trends we need to be on the look out for are and make plans on how I want to play things in the coming year.

This is some of the most important stuff I do all year and I will share with you my ideas over the course of the next week.

Big changes are coming to the markets next year.

Trends change and what has worked for the past few years for people will eventually cease to work.

However, one thing I am just starting to work on is to take my own personal investing and trading to a new level.

When people first get into trading they tend to struggle for the first year or so and lose money.

After that first year they either get taken out of the game and give up or figure things out so to speak.

For long-term players - or people who think they are long-term - often what ends up happening is that they do not know what they are doing at all and then get ruined by a bear market.

When bull markets happen people think investing is easy and believe they are smart because they are making money, but when the bear comes it reveals that they really just were riding a wave without knowing how to surf.

So many people got out of the stock market forever after the crash of 2008 by getting out of the market in 2009 and in the years that followed.

When the next bear market comes a whole new group of investors will be eliminated from the market for good too.

That's just how things work.

Active traders are different though. By trading in and out of the market they put themselves in a situation where they must learn more quickly or lose all of their money if they do not.

That was my experience when I first got into the market.

I talk about this a bit in my book Strategic Stock Trading.

I took 15k and turned it into 50k in six weeks thanks to dumb luck than turned that 50k into about 7k in less than a year.

I needed to find a way to pick out stocks and make entry and exit points or that 7k would go to zero.

Once I did that I started to make money and turned about $15,000 into over $100,000 in roughly a year.

This was in 1999 and 2000 during a time when the Nasdaq bubble burst and market trends changed dramatically.

So I wasn't just a lucky bubble bull.

As the years went by I managed a hedge fund for a bit.

Got into various trends and trades.

Made big money some years.

Did ok others and not so good in one of them.

What I did was make big bets to make big money and and therefore generated giant swings in my account.

The swings ratcheted the account upwards, but they made it too stressful for me to manage other people's money and what I am coming to see is that you can actually create a system where you get less volatility and still can generate big returns.

It is as big of a realization for me as when I first figured things out after my first year in the market.

What I have come to understand after all of this time is that just as important as picking out stocks and markets and trends is how you manage your money.

That of course sounds obvious, but how many books are written about it?

Go in a book store and everything is about picking out stocks and predictions of what is to come.

That's all they talk about on TV and the internet - and frankly that is all most people want to hear about.

But I have been reading papers and studies about that topic over the past few weeks and it's fascinating stuff - in fact I think some of the ideas are being used by the biggest hedge funds and endowments and being kept close to the vest in secret.

I am going to show you one of them today.

One can make money even in a totally random market without even trying to figure out the overall trend if one manages things in an optimal manner.

One of the big things I'm going to do in 2015 is work on this topic and share with you the things I discover.

One of the things I have found may interest you.

It is a press release put out by Standford University in the year of 2000.

It reads:

Tom Cover has the next-best thing to a time machine: He has an algorithm -- a computational procedure -- that uses the past to predict the future. It works as well or better than hindsight, outperforming a pretty good investment strategy: diversifying your stock portfolio and hoping that performance of superstars will more than make up for money wasted on losers.

Cover, professor of statistics and the Kwoh-Ting Li Professor of Electrical Engineering at Stanford, described his investment strategy during an invited talk in Wash., D.C., at the annual meeting of the American Association for the Advancement of Science (AAAS) in February. The strategy uses an algorithm that mirrors universal data-compression algorithms to create the so-called "universal portfolio." Each day the stock proportions in the universal portfolio are readjusted to track a constantly shifting "center of gravity" where performance is optimal and investment desirable. The result? The universal portfolio performs as well as the best strategies that keep a constant proportion of wealth in each stock would have performed in hindsight, "no matter how the market wiggles and squirms," Cover says.

....

A key feature of the algorithm is that the return on investment is exponential, like compound interest. A good way to visualize the tremendous growth potential of an exponent (a number "raised" to some power, like 23 = 8) is to know the legend of the king who unknowingly gave away his kingdom to a peasant who had done him a favor. "I'll give you anything," the grateful monarch is said to have promised. The peasant looked at the king's chess board and asked for one grain of wheat on the first square, two grains on the second square, four on the third square and so on. The innumerate king agreed and unwittingly gave away all his wealth.

With the universal portfolio algorithm, profit grows exponentially, Cover says, and the average of exponential growth rates has the same growth rate as the maximum.

"This is an automatic investment algorithm in the stock market," Cover says. "The portfolio rides the stocks and lives off the fluctuations. It essentially puts a little bit of money on every possible rebalanced investment algorithm, and the surviving algorithms ­ the ones that made most of the money ­ make enough so that your money grows at the same rate as if you had used the best algorithm to start with."

For the full press release go here.

This is the closest thing to a perfect investing system in existence.

To read the paper that explains it go here.

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