Strategy Diversification is a fantastic tool to help reduce the overall risk in a portfolio.
If a tool works and has multiple applications, it makes sense to do so, and the diversification insights we’ve covered in this series fall into this category.
The more familiar you become with a tool, the better you’ll become at implementing it. This is true for correlation. We’ve previously looked at two applications for the use of heatmaps in ascertaining the correlation between
Now we move onto the topic of Strategy Diversification.
Diversifying across trading strategies is one of our four Portfolio Diversification techniques we covered earlier in the series, but just as a reminder, these are
- Asset classes
- Within an asset class
- Trading strategies
The purpose of this is to find out if trading various different strategies can provide a risk relief benefit. By this, we mean can trading multiple strategies within a portfolio increase our risk-return ratio.
We’ve seen the potential benefit of trading multiple assets across various classes and timeframes. Does the same use hold up for strategy diversification?
Let’s now investigate any correlation between two different momentum following strategies, a mean reversion strategy and a break out strategy.
Previously we found out that the (R²) measure of correlation using the delta of price was the most practical way of obtaining the correlation between assets and timeframes.
This isn’t the case with Strategy Diversification
Calculating the (R²) groups the positive and negative correlations making it easier to quickly judge the correlation between assets and timeframes.
However, with trading strategy correlation, we want to see the difference between positive and negative correlation. We are looking for strategies that have a negative correlation with each other.
This is hugely important.
It’s important because if two assets are negatively correlated, trading these in opposite directions has the same effect as trading two positively correlated assets in the same direction. This can have the same negative impact on the risk of the portfolio.
Whereas you need negatively correlated trading strategies to provide any potential benefit.
Although we’re using the same tool, it has different applications, each with varying end results. Furthermore, this is why it’s essential to understand the why, how and what.
Just blindly following something is a risky move and can leave you open to unknown detriments.
As always, get in touch with us @Darwinexchange with any questions, comments or suggestions.
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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.