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Thoughts on Diversification?

  • #1
  • First Post: Sep 2, 2012 2:27am Sep 2, 2012 2:27am
The quote below can be found here. I want to know what professional traders think of it? Do you diversify and how do you diversify? Do you diversify through different asset classes like FX, commodities, equities, real estate...etc, or do you diversify through different strategies?

The “simple is better” idea is not limited to asset class diversification. I think it also extends to diversification by investment strategy, like relative strength or value or low volatility. There’s an underlying logic to it—simple is better, because simple is more robust.


It would be interesting to get different perspectives, personally I diversify on both the asset class criteria along with the investment strategy criteria, I am a big fan of diversification!

P.S. I consider trading in all its forms an investment strategy.
  • #2
  • Sep 2, 2012 5:22am Sep 2, 2012 5:22am
Quoting split_unit
The quote below can be found here. I want to know what professional traders think of it? Do you diversify and how do you diversify? Do you diversify through different asset classes like FX, commodities, equities, real estate...etc, or do you diversify through different strategies?

<b>[i][indent][indent][indent]The “simple is better” idea is not limited to asset class diversification. I think it also extends to diversification by investment strategy,...
Totally agreed. I am also a very big fan of diversification. I diversify across instrument, strategies and time horizons.
But of course you must be sure that each strategy is profitable. Diversifying bad strategies will still make the whole portfolio perform badly.
  • #3
  • Sep 2, 2012 8:43am Sep 2, 2012 8:43am
My plan is to extract funds from my FX account when I discover where the "power curve" falls off and my system is no longer as effective. This is because the problems that keep one from growing a $1,000 account to $1M are categorically different from the problems that arrive when one tries to use the same strategy to grow a $1M account to $100M.

My thoughts are that every system, no matter how successful, reaches a point where it cannot grow the account at the same rate that it did earlier. The best thing to do at that point is withdraw the greater portion of the account and place it in some other type of investment (funds, stocks, etc) which doesn't have to be watched. Then take the remaining balance which is within the "high growth range" and start working it again.

This is actually a principle I learned from cattle farmer Joel Salatin. The new method of grazing cattle (Rotational Grazing) divides the land up so that the cattle chew down the pasture when it's passed out of it's "fast growth" phase. The grasses then begin to grow at the previous faster rate. Same thing goes for growing FX balances.
  • #4
  • Sep 2, 2012 8:55am Sep 2, 2012 8:55am
Quoting FXAssassin
My plan is to extract funds from my FX account when I discover where the "power curve" falls off and my system is no longer as effective. This is because the problems that keep one from growing a $1,000 account to $1M are categorically different from the problems that arrive when one tries to use the same strategy to grow a $1M account to $100M.

My thoughts are that every system, no matter how successful, reaches a point where it cannot grow the account at the same rate that it did earlier. The best thing to do at that point is withdraw the...
Question is would it make any difference on the overall growth rate?

Assumptions: we have 10 Mio. $. Our growth rate from 10k to 10 Mio. $ has been 100% a year.

Scenario 1:
we take out 9 Mio. $ and invest it in a bond giving out 4% a year, 1 Mio $ stays in the account and gives us 100% a year. Result: Capital is at 11.36 Mio. $ by the end of the year.

Scenario 2:
we leave everything in the account and lets say just get 30% a year instead of our 100%, due to liquidity issues. Result: Capital is at 13 Mio. $ by the end of the year.

In this case scenario 2 is better.
My point is: it really is an indivudal case, depending on the system's performance and what other instruments can provide. Sometimes it is better to diversify money into other asset classes to not have liquidity issues, but sometimes it is still better to leave the money where it is and gain a signficantly lower performance that still outperforms most other types of investment vehicles.

We wanna try to avoid di"worse"ification.
  • #5
  • Edited 9:21am Sep 2, 2012 9:06am | Edited 9:21am
Quoting Custos
Totally agreed. I am also a very big fan of diversification. I diversify across instrument, strategies and time horizons.
But of course you must be sure that each strategy is profitable. Diversifying bad strategies will still make the whole portfolio perform badly.
Thanks for commenting Custos, and I totally agree with you, you have to make sure that your strategy is profitable before you consider diversification otherwise there's no point in diversification. You also have to realize that when you diversify onto other asset classes, your entering a new ballpark with different risks and different price drivers. In other words, you have to be sure that you know about the other instrument before you decide to invest in it and that is what really takes time to master and separates financial manager from financial manager, its their overall expertise in finance.
  • #6
  • Sep 2, 2012 9:15am Sep 2, 2012 9:15am
Quoting FXAssassin
My plan is to extract funds from my FX account when I discover where the "power curve" falls off and my system is no longer as effective. This is because the problems that keep one from growing a $1,000 account to $1M are categorically different from the problems that arrive when one tries to use the same strategy to grow a $1M account to $100M.

My thoughts are that every system, no matter how successful, reaches a point where it cannot grow the account at the same rate that it did earlier. The best thing to do at that point is withdraw the...
I don't understand your reason to diversifying after reaching the goal of 1 million. For you to get to that 1 million with that initial capital on your hands would mean that you have an incredible system, it would also mean that your an outlier, someone whos level of expertise is way beyond the average Joe. Why would you want to diversify away from the FX arena and on to other markets where you have no expertise and where you would throw your money down the drain?

Next, 1 million is nothing in the FX market, it is by far the deepest market out there. 1 million is peanuts in this market, it would probably be easier to turn that 1 million into the 100 million if you found a decent broker and trust me many would give you huge privileges trading that size. Liquidity wouldn't be concern for you it would be an advantage.

Lastly, I would suggest you continue trading the FX market if you were to reach that level of profitability while diversifying away a tiny portion of that account into other vehicles for you to achieve mastery in those new instruments. That way, you reduce risk of new entry into new markets while maximizing your strength in the most liquid markets. Hope I make sense

Split
  • #7
  • Sep 2, 2012 11:59am Sep 2, 2012 11:59am
This thread interest me in some way, though I'm not one of the professional trader, but I do felt, there is a need in diversification to safeguard our total financial capital, because we do not know or able to predict what happen in the future.

As I do not have that much capital to invest in property, I do put a sum of money in local stock market(which I felt safe) for consistent growth(2% average annually, but this 1 year had been good on a 9% increment), its slow and doesn't make much as FX,. I am one who do not believe in putting money in bank due to the low interest rate of 0.1%. I treat my investment as saving account for the future.
The only winner is the one who survive the longest...
  • #8
  • Sep 2, 2012 12:28pm Sep 2, 2012 12:28pm
Question I wanted to ask is. whether diversification for long term or short term investment.
Does any day trader diversify his investment within Fx market or beyond Fx ?

I think diversification will not work for short term period. it will add up to cumulative errors/loss. For long term, yes there are possibilities institutional traders with great literature back up, will diversify their investment.
  • #9
  • Sep 2, 2012 1:57pm Sep 2, 2012 1:57pm
Quoting robert7
Question I wanted to ask is. whether diversification for long term or short term investment.
Does any day trader diversify his investment within Fx market or beyond Fx ?

I think diversification will not work for short term period. it will add up to cumulative errors/loss. For long term, yes there are possibilities institutional traders with great literature back up, will diversify their investment.
I used to day trade equities professionally and attest to the importance of diversification, day traders diversify strategies and positions. You can't have one trick that works all the time, you need to diversify and have weapons to tackle the market in different environments. Volatile markets when the VIX was above 20 are different from the market when the VIX was below 20 or above 30. No one system works all the time, if you fail to have other tricks you cant expect to make money consistently unless you are able to identify periods where your system doesn't work and your able to sit out this period in anticipation that your systems comes back to work again.

I also feel that day trading position diversification in the FX market is more difficult than equities, because almost all the major pairs with thin spreads (ideal for daytrading) have either the USD or the EUR as a leg. This makes diversification much more difficult than equities due to correlation. An of equities of diversification where you have stocks in different industries and sectors that do not correlate with each other could KO (Coca Cola) whitch correlates negatively with ACHC (Acadia Healthcare Company), this negative correlation makes a good day trading opportunity to diversify day trading setups.

So yes, diversification is possible for day traders.
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  • #10
  • Sep 2, 2012 2:01pm Sep 2, 2012 2:01pm
Quoting kinspk
This thread interest me in some way, though I'm not one of the professional trader, but I do felt, there is a need in diversification to safeguard our total financial capital, because we do not know or able to predict what happen in the future.

As I do not have that much capital to invest in property, I do put a sum of money in local stock market(which I felt safe) for consistent growth(2% average annually, but this 1 year had been good on a 9% increment), its slow and doesn't make much as FX,. I am one who do not believe in putting money in...
Good job! 9% is excellent! Keep that up and you will someday have alot of capital to allocate You are setting yourself up to be a professional portfolio manager
  • #11
  • Sep 2, 2012 10:54pm Sep 2, 2012 10:54pm
from what I have seen and read, the current financial crisis was as bad as it was because the tools to measure risk and the models that assumed diversification are wrong.

I do not believe one can truly diversify, as a systemic shock will impact all assets classes. In my opinion although I am not a financial expert...one must think of correlation coefficient, and diversify with risk on and risk off environment in mind.

as you can see for yourself in 07 and 08 Gold also took a dive, securities, bonds, etc.... the rebound was more pronounced in some assets, but the dive was a systemic one.
AVT INVENIAM VIAM AVT FACIAM
  • #12
  • Sep 2, 2012 11:37pm Sep 2, 2012 11:37pm
Quoting the redlion
from what I have seen and read, the current financial crisis was as bad as it was because the tools to measure risk and the models that assumed diversification are wrong.

I do not believe one can truly diversify, as a systemic shock will impact all assets classes. In my opinion although I am not a financial expert...one must think of correlation coefficient, and diversify with risk on and risk off environment in mind.

as you can see for yourself in 07 and 08 Gold also took a dive, securities, bonds, etc.... the rebound was more pronounced...
I agree with you redlion, most institutions got pounded using conventional risk management methods like VAR (Value at Risk), according to investopedia VAR is:

Definition of 'Value at Risk - VaR'
A technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.

Investopedia explains 'Value at Risk - VaR'
VaR is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. VaR is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.



Simply put, VAR is the estimated loss a portfolio will take in an outlier event an event that only occurs 1% of the time. An event that is 3 standard deviations from the mean. These events could be like the flash crash in US equities or any other crash that rarely occurs.

The problem with VAR is that it gives you the estimated value you can lose according to historical price movements on such events, THAT AMOUNT IS NOT THE MAXIMUM AMOUNT YOU CAN LOSE, and that is where institutions got hit. They based their models on the VAR and got slammed for it.

Hedging comes in where diversification fails, institutions don't have our advantage to enter at will, they build LARGE positions that are not easily disposable of, so what do they do if the perceive that the market is up for a rough ride? They sometimes hedge their positions/portfolio by either selling the instrument itself short or by shorting futures that correlate highly with their position. Institutions hedging with futures is one of the main reasons the futures are as liquid as they are.

Options also play an invaluable tool in risk management and according to investopedia, options are:

Definition of 'Options Contract'
A contract that allows the holder to buy or sell an underlying security at a given price, known as the strike price. The two most common types of options contracts are put and call options, which give the holder-buyer the right to sell or buy respectively, the underlying at the strike if the price of the underlying crosses the strike. Typically each options contract is written on 100 shares of the underlying.



An option gives the buyer the RIGHT but not the OBLIGATION to buy/sell an instrument above/below a strike price before expiration. An example to a call option would be stock XYZ that is currently trading trading at $30 with a strike price of $32 that expires 1 month from now. In a simple world two scenarios can happen to this option:

a. It goes up after you purchase the option to $34 and decide to excersize the option after it goes above the strike price of 32 and you realize a profit of $2. An option's standard contract's size is 100 shares, so in this case you would realize a profit of $100*2=$200 on your 1 option contract.

b. It goes down after you purchase it to $22, your loss would only be the amount you paid for the option, in this example that would be $2*100=$200 (excluding commission). You wouldn't lose $12 as you would have had you held the stock, your loses would have been $200 instead of $10*100= 1000.

Of course this is how options work in a simplistic world, and it is also the basic assumption of how a call option works. As you can see from the XYZ example, the financial manager avoided a disastrous loss by trading options which proved to be an invaluable risk management tool. Of course options exist for almost all financial instruments including the FX market.
  • #13
  • Sep 3, 2012 1:45am Sep 3, 2012 1:45am
Quoting split_unit
The quote below can be found here. I want to know what professional traders think of it? Do you diversify and how do you diversify? Do you diversify through different asset classes like FX, commodities, equities, real estate...etc, or do you diversify through different strategies?

<B>[i][indent][indent][indent]The “simple is better” idea is not limited to asset class diversification. I think it also extends to diversification by investment strategy,...

The principle of diversification in financial theory is grounded in statistical analysis of risk. It is provable statistically that all forms of diversification reduce specific risk, that part of total risk that is directly linked to that asset. It is separate from systematic risk, the other part of total risk that belongs to the market as whole. Perfect diversification in theory can remove all specific risk to leave just market risk. Repeat the trick at different levels - individual assets, asset classes, investment strategies, etc. - and you keep reducing risk towards a ststistical minimum.

This is why most professional investment & trading organisations diversify. They are trying to achieve the optimal trade-off of return achievable for any given level of risk assumed.

The problem is that you reduce absolute potential return along with the risk because diversificaton is essentially hedging. For any given event you gain something here and lose something (hopefully less!) there with diversification. You also need rather greater skill sets and resources to be expert at many things rather than just one. With an 'all your eggs in one basket' approach you can win much bigger if you are right but risk being properly scrambled if not.

So to what extent you diversify depends on your attitude towards risk and potential return, and on your skill set and resources.
  • #14
  • Sep 3, 2012 2:17am Sep 3, 2012 2:17am
Quoting marcmarc
The principle of diversification in financial theory is grounded in statistical analysis of risk. It is provable statistically that all forms of diversification reduce specific risk, that part of total risk that is directly linked to that asset. It is separate from systematic risk, the other part of total risk that belongs to the market as whole. Perfect diversification in theory can remove all specific risk to leave just market risk. Repeat the trick at different levels - individual assets, asset classes, investment strategies, etc. - and you keep...
Thank you for your insightful comments marcmarc and I agree with what you wrote except for this part where I beg to differ:

"The problem is that you reduce absolute potential return along with the risk because diversificaton is essentially hedging. For any given event you gain something here and lose something (hopefully less!) there with diversification. You also need rather greater skill sets and resources to be expert at many things rather than just one. With an 'all your eggs in one basket' approach you can win much bigger if you are right but risk being properly scrambled if not."


Here's a paper on the point I wish to make, diversification does not reduce returns over the long run it increases it. It is more than possible to have superior returns in the short run from non-diversified positions but you also run the risk of ruin in the long run. You should also check out the "All Weather Approach" by Ray Dalio who runs the biggest hedgefund in the world for further evidence that diversification increases returns in the long run instead of reducing it.

As for this part of your comment:

"You also need rather greater skill sets and resources to be expert at many things rather than just one. With an 'all your eggs in one basket' approach you can win much bigger if you are right but risk being properly scrambled if not."


I totally agree with you, expertise does result in higher returns, however, diversified expertise results in even higher results and that is as I argued earlier what differentiates financial manager from financial manager.

That being said, I am not an expert of risk management, I consider myself a humble student of the market, if anyone finds what I wrote inaccurate in anyway, I welcome any criticism as long as their supported by facts.

Split
  • #15
  • Sep 3, 2012 3:15am Sep 3, 2012 3:15am
Quoting split_unit
Thank you for your insightful comments marcmarc and I agree with what you wrote except for this part where I beg to differ:[indent]"The problem is that you reduce absolute potential return along with the risk because diversificaton is essentially hedging. For any given event you gain something here and lose something (hopefully less!) there with diversification. You also need rather greater skill sets and resources to be expert at many things rather than just one. With an 'all your eggs in one basket' approach you can win much bigger if...

Hi,

I read the paper you mention, solid stuff. I believe our discussion centres on what we mean precisely by return. Effective diversification, as practised by the organisations quoted in the paper, are achieving a 'diversification premium' - extra return for risk assumed, compared to a benchmark. If true, this is evidence of genuine skill on behalf of the managers concerned. With their blend of diversification they are getting nearer the optimal trade-off of return for risk than the raw benchmark portfolio.

Note this is extra return for risk assumed, the 'diversification premium'. It represents the more effective shedding of specific risk compared to the benchmark. If my portfolio (or benchmark for that matter) was just a volatile single security on a single strategy, I am assuming maximum specific risk which might pay off spectacularly well or badly compred to the efficient portfolio.

Statistically, the potential return of my one security/strategy is likely higher than the diversified portfolio but the risk assumed is much, much, higher. I have 'improved' the potential return but only at the cost of massively higher risk and a much worse risk-return trade-off.

Diversification is not per se increasing return, my simple one security portfolio likely has a higher potential return. What it is doing is improving the risk-return trade-off. You are getting more bang for your buck in terms of return for risk assumed, not necessarily more absolute return.

After all that theory, my head now hurts! In pragmatic terms, I fully agree with you. Putting all your eggs in one basket mostly just massively increases the risk of ruin, and that's not a great idea. You might win big now and again but in the end you will be wiped out. A diversified approach takes a better, more middle, path of more consistent returns and very little chance of being wiped. All one needs to do now is work out what constitutes effective diversification!
  • #16
  • Sep 3, 2012 3:43am Sep 3, 2012 3:43am
Quoting marcmarc
Hi,

I read the paper you mention, solid stuff. I believe our discussion centres on what we mean precisely by return. Effective diversification, as practised by the organisations quoted in the paper, are achieving a 'diversification premium' - extra return for risk assumed, compared to a benchmark. If true, this is evidence of genuine skill on behalf of the managers concerned. With their blend of diversification they are getting nearer the optimal trade-off of return for risk than the raw benchmark portfolio.

Note this is extra return for...
Fantastic post marcmarc I consider your contributions valuable, and from you language I can tell that your an experienced, well learned trader/investor. You're right many theories in the end give us all headaches and it is this pursuance of excellence that makes us who we are
  • #17
  • Sep 4, 2012 10:38am Sep 4, 2012 10:38am
Hi Split, I have found your new thread. I will follow it with much interest.

Greg.
  • #18
  • Sep 4, 2012 12:59pm Sep 4, 2012 12:59pm
what are the high liquidity uncorrelated market or instruments according to you guys ?

So, it can be helpful in diversification of portfolio.
  • #19
  • Sep 4, 2012 1:10pm Sep 4, 2012 1:10pm
Quoting gregofx
Hi Split, I have found your new thread. I will follow it with much interest.

Greg.
Hey gregofx, your welcome to my threads anytime my friend.
  • #20
  • Sep 4, 2012 1:51pm Sep 4, 2012 1:51pm
There are those that say "don't put all your eggs in one basket".

There are those that say "put all your eggs in one basket"

I believe too much diversification is unproductive and too little is too risky.

Unless you want to take the chance on high risk for high reward, best bet is somewhere in between for long term safeguarding AND profitability that is worth the time and effort. I personally like to diversify between 3 or 4 instruments at a time.

So my ideal cliche would be... "Put all your eggs in only a few baskets and put them right in front of you where you can watch them all"
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