Measuring Correlation to inform your Portfolio Diversification Strategy

Measuring correlation is as important as portfolio diversification itself. We can’t diversify our portfolio without first measuring correlation between the assets and strategies in our portfolio.

In fact, not measuring correlation will potentially lead to the risk we are exposed to increasing. By having exposure in two correlated positions, we are effectively doubling our exposure to this risk.

So how do we measure correlation?

The method for measuring correlation will differ depending on what technique we are using to diversify our portfolio. Remember the four techniques we covered previously in this series. These were:

• Across asset classes
• Within the same asset class
• Across different timeframes

Throughout this mini-series, we’re going to look at different methods of measuring correlation.

To kick things off; we are going to start with the Coefficient of correlation (r) or Pearson’s r, as it’s also known. Karl Pearson developed the idea. He also founded the world’s first university statistics department at the University College, London.

Pearson’s r measures the strength of a linear relationship between two variables. It does this by creating a line of best fit between variables and measures the distance of each variable to the line of best fit.

This results in a range of results between -1 and +1. -1 would be a negative correlation, 0 would be no correlation and you guessed it +1 would be a positive correlation.

What do we mean by positive and negative correlation?

An example of a positive correlation would be two separate trades in the same direction, on the same asset. When the asset price rises; both the trades will gain, due to the positive correlation between the two trades.

A negative correlation would be simply the opposite. Two separate trades in different directions on the same asset. When the asset price rises one trade will gain whilst the other loses and vice versa if the asset price falls.

Positive and negative correlation can both negatively affect our portfolio.

So why measure them individually?

We don’t have to. There is another way to measure correlation. The coefficient of determination (R²).

This takes Pearson’s r and squares it. Doing so removes the negative part of the range leaving a range of 0 to 1. 0 would equal uncorrelated and 1 would equal either positively or negatively correlated. As both positive and negative correlation will negatively impact the portfolio this way would seem to make sense.

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Risk disclosure:
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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.

What does Enough Portfolio Diversification look like?

How much is enough portfolio diversification? Reminds me of a song.

Cue Michael Jackson music. Don’t stop ’til you get enough. Was Michael talking about portfolio diversification when he wrote that song? As much as I’d love it to be true, I don’t think it can be.

So, what might a diversified portfolio look like?

Can we have too much portfolio diversification?

What does enough portfolio diversification really look like?

So many questions. Let’s break it down into each technique we’ve looked at so far.

Diversification across asset classes

We could look to trade Forex and stocks. By trading these two different asset classes we would expect that if there were a stock market decline it wouldn’t also lead to a decline in the FX market. We could take it a step further and trade commodities as well.

Diversification within the same asset class.

We could then break down each asset class and look to trade more than one asset within each asset class. Maybe a USD denominated FX pair and a JPY cross. We could trade stocks from different sectors or industries. Then we could trade a metal like copper and a soft commodity like coffee.

Remember though, due to the random nature of price action even two uncorrelated assets will exhibit similar behaviour some of the time. This means the max diversification benefit can only be achieved a maximum of 50% of the time when diversifying across 2 assets. This does increase with the more assets you trade.

Remember these assets need to be uncorrelated.

It’s also important at this point to look at how much the volume of trades has increased. In the above example, we have 2 FX trades, 2 stock trades and 2 commodity trades. Each of those will eat into our available margin.

Diversification across timeframes.

If one of the FX trades, trades the daily timeframe we could look to run a strategy on the 15min as well. Or we could trade one of the stocks, maybe a value stock, long-term and look to hold for a period of months. Then trade a tech stock short term, perhaps some form of intraday strategy.

We’ve already partially covered this in the above example. There may have been some overlap in using the same strategy in different asset classes.

But we could also look to harness different alphas within the same asset class. This could take the form of a momentum strategy and a mean reversion strategy within the same asset class.

The above is just a hypothetical to illustrate just how flexible diversification can be and the potential power it holds. But with great power comes great responsibility. Just because we have these tools at our disposal doesn’t mean we need to use them all.

It’s going to take a vast amount of time to backtest and implement the above. It’s also going to take a sizeable chunk of capital compared to just running two or three strategies. You’ll need to decide which applications are best suited to your portfolio.

To sum up

You can’t have too much diversification from a portfolio point of view. You can however have too little time and money to implement them all successfully. We need enough portfolio diversification that we get the benefit but not so much that it requires too much effort. To reiterate.

You’ll need to decide what’s best for you.

You need to find a balance between effort and value. Only you will know what that is as we all have different circumstances.

What’s your preferred method of diversification?

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:
https://www.darwinex.com/legal/risk-disclaimer

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.

Benefits of Portfolio Diversification | Using Multiple Asset Classes

So far in this series, we’ve talked about the benefits of portfolio diversification, what it is, market randomness and trying to protect against black swans.

Today we touch on another way to diversify your trading portfolio. This is to diversify across asset classes.

An asset class is a group of assets that have similar characteristics.

Examples of common assets classes are stocks and forex.

Examples of assets that make up these asset classes are Apple & Tesla (stocks), EURUSD and USDCAD (forex).

Potential benefits of portfolio diversification across different asset classes.

Each asset class will exhibit different behaviour, some of the time. By diversifying our portfolio across multiple asset classes, we can expect some assets to be going up, as others are coming down.

This can have a great benefit to the overall performance of the portfolio. If there is a crash in the stock market, you wouldn’t expect AUDJPY to fall off a cliff.

Similarly, if GBPCHF goes haywire, you wouldn’t expect it to negatively impact the S&P500.

Portfolio Diversification can help smooth out periods of drawdown and increase the risk-return ratio when using uncorrelated asset classes like in the examples above.

See how diversification benefits your portfolio on the Darwinex platform.

Darwinex provides a host of different metrics you can use to analyze various aspects of your portfolio.

For instance, under the assets and timeframes tab, it displays the percentage share each traded asset makes up of the portfolio.

These metrics can give valuable insight into the robustness of your portfolio.

Throughout this series, we have covered various insights into different ways of implementing diversification strategies into your trading strategy, both at a trade level and a portfolio level.

Diversifying across asset classes can be another great tool to utilize.

Yes, portfolio diversification is a tool. It’s a handy tool, but a tool nevertheless.

It’s up to the trader to decide if, when and where to use it.

When deciding upon which tools to use in your trading portfolio, always backtest to see what benefit it may provide.

Feel free to share some backtest comparisons of your undiversified and diversified returns on social with #darwinexchange.

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:
https://www.darwinex.com/legal/risk-disclaimer

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.

Introduction to Diversification | Reducing Risk by Portfolio Trading

Welcome to our latest content series on Portfolio Diversification.

It aims to provide a higher-level view of portfolio management ideas, rather than the specific indicators highlighted in the previous series Algo Trading for a Living.

We’ll kick things off with an Introduction to Portfolio Diversification.

Diversification is a really powerful tool for reducing the overall risk of your portfolio.

We’re going to look at the fundamental reasons diversification is an important part of any portfolio level trading strategy.

Firstly, what is “diversification” anyway?

We’ve probably all heard the saying ‘Don’t put all your eggs in one basket’; this refers to diversification.

In terms of finance, Portfolio Diversification is a term used to explain how trading portfolios can be constructed in a way that reduces the overall risk of the portfolio.

Diversification also smoothens drawdowns, in a way that is difficult to achieve by trading the components of the portfolio separately.

During this series, we’re going to look at four diversification techniques; starting in this video with a simple example using two uncorrelated FX currency pairs.

Which two FX pairs do you think we’re going to use?

Before watching the video, share your thoughts in the comments section below!

In the example, we discuss how to trade these two pairs as a mini-portfolio to help reduce the overall drawdown at the portfolio level.

Diversification is a technique that contributes to lowering the overall portfolio risk enabled by the trading of multiple; uncorrelated-techniques.

Try doing some backtests on other uncorrelated assets.

Did you see any benefit from diversification? Let us know in the comments below!

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:
https://www.darwinex.com/legal/risk-disclaimer

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.