When you mention diversification, most people will immediately recognise that it is a good idea. Most people have heard of the old saying “Don’t put all of your eggs in one basked” and I fully agree.
Of course you should hold more than one stock – I mean if you hold Apple, Facebook, Google, Bank of America and GE then you are diversified right?
Well in a sense yes, because if one of those companies doesn’t do so well then you have a couple of others that might make up for the difference. But this is just one level of diversification and it is has a major flaw.
What is the flaw in the typical approach to diversification?
The fundamental flaw in the typical approach to diversification is that it is only taking advantage of a single level of diversification.
When you hold multiple stocks in your portfolio you reduce company specific risk because you have different companies with different risks in your portfolio. But you are not diversifying against other risks like economic, investor sentiment, currency fluctuations and so on.
Thinking about all of these risks and diversifying against each one is VERY HARD, and chances are you will miss the one risk that you really need to address!
I propose that you think about it from the angle of diversifying how you make your money. When you do this there are 6 levels of diversification to consider.
What are the 6 levels of diversification?
When you take the perspective of a trader, there are six different levels of diversification that you can take advantage of:
- Return Drivers
Let’s look at each of these in turn and see how you can implement them as a private trader:
Just like the “don’t put all your eggs in one basket” example above, all traders should hold multiple positions. Company specific risk and unexpected announcements can make individual positions swing wildly, so the more positions you have the less this will be a problem for you.
No matter how good the story is, don’t bet it all on one or 2 hot stocks. Even the market darlings can fail – Just look at Worldcom, Enron, Goldman and hundreds of others. You just can’t rely on a small number of positions to generate consistent returns!
Regardless of whether you use indicators, a trading system or fundamental analysis, you will have to choose the parameters that will trigger entries and exits.
A simple example is a moving average crossover system – you enter when the 20 day moving average crosses above the 200 day moving average, and exit when it crosses back below. (I am not advocating that as a system, it is simply an illustrative example). In this example there are two obvious parameters: 20 for the short average and 200 for the long average.
Most people would search for the combination of parameters that work best in the past and use those for their trading. A better way is to choose parameters that are in the middle of a range of well performing parameters. But an even better way is to diversify your parameters across the range that works.
So in the diagram above, say the range of good performance was between 24 and 30 days for the short term moving average. Here you would diversify by using several values within this range (say 25 & 29) as slightly different versions of the same system.
If you diversify a couple of key components of your trading system so you have a couple of different versions of the system then you will most likely outperform one single version over time.
There are many Trading Systems that work. Each different system will enter and exit the market at different times. They will also experience profit and drawdown at different times. This makes a hug difference if you are profiting from one while the other is losing. For example:
When you combine two different trading systems into a portfolio you can reduce the volatility of your returns OR achieve higher returns with the same volatility. This is diversification gold!
Trends & patterns can exist on Weekly/Daily/hour/minute charts. Most people will have one natural center when it comes to timeframes. If you create a trading system for your preferred timeframe and then diversify by adding a second timeframe then you can find similar benefits as you get by adding diversified systems as shown above.
If you are a stock trader who only trades in your home market then you are missing another big source of diversification. It is now cheap and easy to trade on all sorts of exchanges around the world so there is no longer an excuse to not consider diversification across other markets.
While most of the world’s stock markets are correlated, they still move somewhat independently day to day. Depending on what your home market is the right market for you to diversify into will differ. You will need to explore and find the right market for you to diversify into.
You may consider going even further – if you a stock trader now you could even consider adding futures or forex or options to your portfolio.
The final level of diversification is based on return drivers. This means you diversify what type of market behavior actually generates a profit for you. There are many types of market behavior that you can profit from including (but probably not limited to):
- Upward Moves
- Downward Moves
- Statistical Relationships
- Mean Reversion
- Increasing Volatility
- Decreasing Volatility
- Time decay
As you get comfortable trading one of these return drivers you can add another one for diversity.
The diversification combinations based on these 6 levels are potentially endless. The more uncorrelated ways of making money you have the better your long term performance will be. You won’t be able to take advantage of them all, but just remember, there is a lot more to diversification than just adding a Google position to you Apple and Facebook holdings!