Despite the -14.3% return in 2022, I think this performance is still acceptable considering that the benchmark (SPY +TLT) showed a -21.7% decline and we have an excess return of +7.4%. Especially considering that the securities and bonds market has experienced the worst decline in the last 50 years.

LargeCap + 10Y Treasuries yield since 1972, volatility-weighted

Of course, the results for SPY and TLT individually have been worse, but the reality is that they almost never fall together (the last time this happened was in 1972-1973) because they have an inverse impulse correlation and must hedge each other. They do that over 95% of the time, but not this year (-28.4% DD SPY +TLT).

SPY 100%; SPY-TLT 50%-50%; TLT 100%

Portfolio Visualizer uses low frequency data, so the real drawdown will always be slightly larger than the one shown in the chart.

Additionally, we had one of the biggest historic movements in wheat when the market went against the arbitrage premium, and of course I was holding this trade at that time. This is an excellent trade idea unless there are rare events (Ukraine exports >10% of the world’s wheat) that we can control using risk management. But everything in order.

The first mistake was hedging with a synthetic option instead of a real option. Surprisingly, it turns out that it doesn’t work when you actually need it.

When there’s extreme volatility in grains, the market simply opens and closes with gaps, preventing a hedge. I always remember that now. If I had done everything right, the final result for 2022 would have been an additional +4% CAGR.

I would like to point out the effectiveness of risk management. Even such rare and destructive events don’t lead to significant drawdowns. Even if we take into account that the option hedge was ineffective.

The second mistake was that I didn’t enter the next wheat trade due to irrational fear of an intensification of the Russian-Ukrainian war and a repeat of last year’s scenario. All the factors indicated that this was a great trade. But I didn’t want to look foolish and make the same mistake twice, because the risk factor hadn’t changed.

One shouldn’t do this. As a result, I didn’t earn about +5% CAGR. It’s always necessary to trade systematically and patiently ignore any factors that have not been backtested on a large sample of data.

Partial correction of the second mistake: it was very scary to enter gas against the backdrop of high volatility and instability of the main gas supplier for Europe. But absolutely all indicators said that this is an ideal trade and the probability of a positive return is more than 90%. Having recent experience with wheat in mind, I entered the trade through the pain.

UNG short and hold, no technical analysis, only fundamentals. The risk is limited through an option.

The main mistake was that I didn’t buy and hold small positions in commodities due to their high correlation with indexes.

The most important rule now is to remember 1973 and 2022. We should always try to keep a positive premium on the commodity in the portfolio, about 10-15% allocation. This is because very rarely, but still, we’ll run into a situation like this: the market is down, government bonds are down, inflation is up, and the commodity is strongly up. In this way, the profitability of the portfolio is almost not reduced, but in such rare cases, the drawdown of the portfolio is reduced by about 1/3.

The most important achievement in 2022

I’ve learned to create my own custom securities indexes that work much better than traditional indexes. They produce more than 2x returns with lower volatility and drawdowns than traditional index ETFs.

I managed to test the approach in practice on a small account and get +6.9% vs -19.9% RUSSELL 2000 or +26.8% excess returns in 2022 in the recession. This means that with conservative risks we’ll be able to get an additional >10% CAGR to the standard conservative expectation of our approach, raising it to +35% CAGR. I am now absolutely sure that a systematic return of >30% CAGR is possible with relatively conservative risks.

Important: always subtract the return of the index from the return of the securities portfolio to filter the average market direction and determine your potential return. When the index shows its average return after some time (+6.3% GAGR for Russell since 2008), the strategy should generate approximately 0.291+0.063 = 0.331 or +33.1% CAGR in the long run.

It’s a bit of a shame that it was not possible to fully implement this strategy into the portfolio from the beginning of 2022, as I had to test the performance on a small account size first.
In 2023, I’ll introduce this strategy into trading by completely replacing the securities indexes with my own index.

Read more about the securities strategy here.

Small Cap Stock Strategy is now available to everyone who has learned my trading approach.

Of course, now I understand that if I’d had that experience I could have had a slightly positive return at the end of the year, and thus the strategy could have generated a three times higher excess return, even though the benchmark fell dramatically. But unfortunately, things often go wrong in real trading. The foundation of trading should be strong enough to generate alpha even with far from perfect execution. It’s incredibly encouraging to see that this is possible even without any experience of trading in such difficult years.

I wish you a Happy New Year and successful trading in 2023 🙂