Are you Diversified? No Really Really Diversified?

Diversification is a catch-phrase that is often heard in relation to stock investments. The typical mantra is to diversify along market capitalization (small cap to large cap) as well as along the investment risk strata (value through growth). The typical Morningstar rating box when evaluating mutual funds will look something like this.

But look at this chart of Growth vs. Value.

Or this one of Small, Medium, and Large Cap

That is NOT diversification.

But are there other forms of diversification that might be able to not only reduce risk but also smooth the equity curve? I believe there are such possibilities. What about diversification of  trading timeframe? For example intraday trading up through long term buy and hold. This group would contain:

 

daytrading (intraday holding period)

 

swing trading (1-10 day holding period)

 

position trading (can hold from months to years)

 

long term holdings (typically holds for years)

 

Now lets assume you could apply an edge in each of these timeframes. Would not this create a truly diversified portfolio? With the ability to ride out dry periods and weaknesses that might be exposed in individual categories in the short term but have persistence and over the longer term. Now let’s take this diversification theory a step further. Let’s diversify among asset classes that have limited correlation. This group would contain:

 

Equities (stocks and their derivatives such as mutual funds, ETF’s, individual stocks)

 

Fixed Income (debt securities from corporate to government, ETF’s)

 

Commodities (metals, softs, grains, cattle, energy, currencies, and ETF’s that track these)

 

As we open ourselves to these other asset classes and timeframes we can see how limited the conventional diversification theory is. ETF’s will be an excellent tool in this process of diversification. With the sheer amount and varying styles that will be hitting the market, the ability to track hedge fund type strategies will be in the hands of average investors.

Hedge funds employ these strategies but rarely is this much diversification applied by one manager. In reality each fund has their favorite strategies and applies them across the fund with an eye on performance versus diversification. The fund of fund concept will incorporate some of these disparate ideas into one portfolio and try to achieve true divesification of risk, by employing the techniques I have just laid out.

In my own portfolio I try to apply these concepts of true diversification by applying a series of systems that have a statistical edge and merging them into one solid system. You see although some may see each technique and strategy as disparate systems, I tend to see the “system” as the application of the ideas of diversification into one living breathing and adaptable portfolio. With the plethora of trading products available to the retail trader and commissions cost as low as they are there is no major obstruction to applying these techniques in the individual traders account.

Tomorrow I would like to address how to apply position sizing across various strategies down to individual trades and how I construct my portfolio presently and where I see changes in the future.

 

 Dave Johnson