PnL-based risk allocation

PnL-based risk allocation is probably the most intuitive portfolio allocation/optimization technique. It says to start all available trading strategies with an equal amount of risk when we have no live trading history. Then, as time goes on, we rebalance the portfolio-allocation amounts based on the average performance of each trading strategy.

Let's say we want to rebalance our portfolio of trading strategy every month. Then at the end of every month, we look at the average monthly PnLs of every trading strategy we have in our portfolio and for the next month, every trading strategy gets risk proportional to its average monthly performance, the best performers get the most risk and the worst performers get the least risk allocated to them. This makes intuitive sense and is often how a portfolio allocations are performed. It uses historical performance as a proxy for future performance, which obviously isn't always true but is a good start.

It, however, does not factor in that different trading strategies might be taking different kinds of risks, and a safer trading strategy might get less risk allocated to it in favor of more volatile trading strategies. This allocation method also does not take correlation of returns between different strategies into account while allocating risk to different trading strategies, which can end up causing very high volatility for the portfolio returns.

The interesting point here is that eventually the strategy with the best historical performance ends up with the majority of the risk allocation. Also, strategies that haven't been performing as well as their peers gradually have their risk cut down to a very small amount and often don't recover from there.

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