MONEY MANAGEMENT
Improve Profitability, Reduce Risk
Diversification And Your Portfolio
by Phil Abel
Thinking about adding financial and commodity futures to your trading? Here's how it can improve profitability and reduce risk.
Stockpicking can enhance a portfolio, but only to a certain extent. If you incorporate additional markets such as financial and commodity futures, it can substantially enhance performance and reduce risk. The trader or investor who has chiefly invested in stocks and has not yet considered the possibility of diversification into other markets may find adding financial and commodity futures to his or her portfolio a highly lucrative venture.
The past decade has witnessed stock prices rising to unbelievable highs and then sinking to multiyear lows. All too many investment and trading accounts have taken hits. By employing a more diverse array of assets and some basic trading tactics, a trader could potentially be at or near all-time equity highs today, instead of suffering extended drawdowns.
PRINCIPLE OF DIVERSIFICATION
Anyone who has attended an introductory finance or investment class is probably familiar with the principle of diversification, which posits that if you add additional investments to a long equity portfolio, the overall volatility of your portfolio can be reduced. Figure 1 summarizes the results of a 1987 study that showed the impact of the size of a portfolio on diversification. As the chart illustrates, the more equities that are added to a portfolio, the lower the volatility of the portfolio. Moreover, with a portfolio of just 10 to 20 stocks, nearly the same diversification effect can be realized as with a portfolio of 500 or more stocks.
One more concept that can be illustrated from Figure 1 is that of undiversifiable risk, or the risk that cannot be eliminated by stock selection alone. No matter how many stocks are put into the portfolio, the portfolio will still witness a certain degree of volatility (about 18% per year, on average) due to equity market risk as a whole. This is because stocks, regardless of sector or capitalization, exhibit varying degrees of correlation.
Figure 1: Diversified vs. undiversified risk of a stock portfolio. Adding more stocks to a portfolio can eliminate much of the volatility and risk. However, there is always an undiversifiable level of risk that cannot be eliminated through stock selection alone.
To accomplish further risk control, three more tools can be employed: 1) a systematic trading model to control losses and objectify trading decisions, 2) diversification into additional market classes besides stocks, and 3) trading both long and short.
...Continued in the October 2003 issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the October 2003 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2003, Technical Analysis, Inc.
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