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.
Diversification across trading strategies.
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?
Tag us on Twitter (@Darwinexchange) with your thoughts.
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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.