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Balance Risk Diversified Portfolio

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:
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.

portfolio diversification strategies

Portfolio Diversification Strategies | Practical Implications

How important is portfolio diversification?

When trading we will sometimes have to make sacrifices. There just aren’t enough hours in the day to do everything. We need to prioritize what we do effectively to gain the most benefit.

Depending on whether we are a discretionary trader or an algorithmic trader, will impact how you implement a portfolio diversification strategy.

Key considerations when implementing a Portfolio Diversification strategy

Time will always be a consideration. As discussed previously, diversification is an important component of risk management at the portfolio level, but it is not the ‘golden bullet’.

Portfolios need to be looked at holistically.

Where are our efforts best focused on at this time? It may be that your underlying trading strategy still needs work before you can benefit from implementing a diversification strategy.

Or it may be that your strategies are nice and robust, and you can now focus your time optimizing the portfolio risk side of things.

Ultimately, you’ll need to decide where your time is best served.

But how do I know what to do?

In the video, Martyn goes over some of his personal experiences with how he trades his portfolio of strategies. They don’t just provide you with great educational content, our presenters also trade the markets themselves. Where do they find the time!

Another consideration is how you trade.

Do you trade manually, or do you trade using automation?

If you’re a discretionary trader; your skill, and the number of monitors you have, may limit the number of assets you can manage at once. Again, your circumstances will dictate what works best for you.

A long-only, passive portfolio will need a different approach to diversification than that of a more active portfolio like the example in the video.

So, what can we take away from this?

We need time to implement what we know, and we need to know what to implement when we have the time.

Argh yes, the circle of life trading decisions.. 😌

Take a step back from your portfolio and look at it with a bird’s eye view. What is the most impactful thing you can do now that will help improve your trading?

Did you know we have a Slack group dedicated to trading?

Feel free to join here. We’d love to connect and talk shop.

If you’re new to portfolio diversification, consider reading this post to get some background on the topic.

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.