Humans are programmed to make sense out of the world.
There are many ways to do this, but let's boil it down to three.
We are pattern matching machines. Religion, art and science give us mental sustenance.
Part of the issue we have in finance is a lack of patterns.
Anti-patterns cause cognitive dissonance. But never fear there are always a bunch of charlatans willing to conjure patterns in return for your cash.
When you free yourself of the desire for patterns, all you have left is the noise.
Listen to this.
This is an orchestra told to make a wall of noise.
How successful are they?
The orchestra breaks down into melody
Or maybe it's just my ears subconsciously making sense out of the hum.
Probably a bit of both - but I am sure a computer would be more successful.
Humans in an orchestra aren't accurate enough. They can't play their different frequencies at exactly the same volume in order to generate true white noise.
Just like market participants, I suppose.
Someday I'll try to take Sonic Pi for a spin and do the same with sound.
The Duality strategy also relies on producing white noise. Each stock pick is hedged in such a way that it has little covariance with other stocks.
It is not flawless however (thanks to Roger Swierstra who suggested a tweak which might help in the next iteration).
In any case, I have combined the 'dropout' portfolio to the current DJIA constituents; lengthened the backtest to '03 by removing Visa (IPO'ed in '08) and GM (bankruptcy '09).
The Sharpe is 1.
The strategy reweights every day, but monthly weighting is quite efficacious also (e.g. in this case, the Sharpe is 0.73).
You can't just throw any stocks into your portfolio, but if you pick a handful of decent stocks, this will help.
The equal weighted version of this portfolio results in a Sharpe of 0.34.
For every AAPL there's an AIG!
If covariance is melody, then pairs trading might be a melodious tune. The Duality strategy is the opposite, an attempt to get closer to white noise and anti-patterns.
Or an attempt at making musical noise from the markets.