How to Balance Risk across your Diversified Portfolio

Why do we want a Diversified Portfolio when it reduces our absolute returns?

If we think back to our previous video, remember that we’re trying to increase our risk-reward ratio, not absolute returns. We want to balance the risk of our portfolio.

We believe that risking 1 to get 1 is better than risking 10 to get 5.

Now, this objective is clear, let’s take a look at how we’re going to balance risk across our diversified portfolio.

Last time we covered 4 techniques to implement portfolio diversification into our portfolio.

These were across:

  • Asset Classes
  • Uncorrelated assets within an Asset Class
  • Timeframes
  • Trading Strategies

But how do we assign capital or risk to each of these?

We’ve identified 4 ways to balance risk across a diversified portfolio and we’ll go over each of these now. 

  1. Fixed position size per trade. This is by far the easiest to implement but by no means an effective way of weighting your portfolio strategies. This method affects our risk by: 
    • The size of the stop-loss.
    • The volatility of the underlying asset
    • It will change based on the account equity
  2. Equivalent position size per trade. This is similar to the 1st way, albeit a little more dynamic. All the above will apply with the added consequence of varied position sizes depending on open positions. 
  3. Equivalent risk per trade. Probably the most well-known and widely used. Here we balance the risk for each trade. We adjust the position size factoring in the stop loss size. This means that each trade will have the same risk expressed as a percentage of account equity, one thing this approach doesn’t take into account is the correlation of each position. So 2 positions in correlated assets will effectively increase the risk to the portfolio.
  4. Reward/risk ratio portfolio optimization. This takes into account the following 3 factors: 
    • The relative correlation between each diversification technique.
    • Alpha of each portfolio component.
    • The volatility of each underlying component.

This way is the most complicated but as you can see, provides us with the most comprehensive approach to a Diversified Portfolio. As it’s the most complicated we’re only able to scratch the surface in this post and will need to cover this in more depth in future episodes. 

As always Darwinex has you covered when providing you tools and metrics to help keep track of the inner workings of your portfolio.

We’re going to look at 2 Investible Attributes that can provide valuable insight into the risk exposure of your portfolio.

The first is the Risk Stability (Rs) investible attribute.

This measures the consistency of the risk. A nice flat line means the risk is fairly predictable over time and can be considered a positive.

Large peaks and troughs mean the behaviour of the trading strategy may be unstable and can lead to unpredictable levels of risk. 

Next up is the Risk Adjustment (Ra) investible attribute.

The Darwinex platform is unique in that, Darwinex manages the risk of investments in DARWIN assets independently of providers, ensuring that they carry a monthly maximum target VaR (95%) of 6.5%.

This shows up on the Ra investible attribute as outliers on the chart and is coloured differently. 

Brought to you by Darwinex: UK FCA Regulated Broker, Asset Manager & Trader Exchange where Traders can legally attract Investor Capital and charge Performance Fees.

Risk disclosure:

Content Disclaimer: The contents of this video (and all other videos by the presenter) are for educational purposes only, and are not to be construed as financial and/or investment advice.

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