New traders and investors are told to “diversify their portfolio”, which will supposedly lower risk and decrease the chances of their portfolios blowing up. The diversification mantra might have made sense 30 years ago when inter-market correlation was low, but it doesn’t work that well anymore.
- New traders and investors shouldn’t diversify between assets and markets.
- Intermediate-advanced traders and investors should diversify between trading and investment strategies.
Problem with asset diversification
Diversification between assets and markets (e.g. trading 5 different markets at the same time) makes sense IF those assets and markets have a low degree of correlation.
This way if one market tanks and damages your portfolio, the other markets won’t be hurt too badly. The purpose of diversification is to “not put all your eggs in one basket”. That way if one egg breaks, the other eggs will still be fine.
This is a good idea in theory for new traders and investors. Beginners generally don’t know what they’re doing or are prone to making errors. So although diversification does lead to decreased investment returns, it also leads to less risk, which is what beginners should be taking.
But the problem is that this theory is becoming less and less useful in practice. Markets are becoming more and more correlated nowadays.
For example, let’s assume that you are a stock trader. It doesn’t really matter if you “diversify” between stock markets. You can trade U.S. stocks, German stocks, UK stocks, Canadian stocks, and Chinese stocks. These markets all have a high degree of correlation with the U.S. stock market.
So when you trade these 5 markets to “diversify” your portfolio, you are essentially putting on 1 big trade! The strong correlation means that these markets aren’t really diversified. If you are right in 1 market = you will be right in all 5 markets. If you are wrong in 1 market = you will be wrong in all 5 markets.
Here’s a 20 day rolling correlation between the S&P 500 (U.S. stock market) and DAX (German stock market). Notice how these 2 markets have a strong degree of positive correlation.
Here’s a 20 day rolling correlation between the S&P 500 (U.S. stock market) and SSEC (Chinese stock market). Notice how these 2 markets have a strong degree of positive correlation.
Here’s a 20 day rolling correlation between the S&P 500 (U.S. stock market) and TSX (Canadian stock market). Notice how these 2 markets have a strong degree of positive correlation.
Markets tend to be strongly correlated when they are going down. This means that diversification is almost nonexistent precisely when you need diversification the most – when the market is falling.
Sometimes markets are uncorrelated at the moment. That’s because the fundamental drivers impacting those 2 markets are different. But when a fundamental driver that can impact both markets reappears, those 2 markets will have a strong correlation. Diversification becomes nonexistent.
For example, falling or flat inflation has no impact on the stock market and U.S. Dollar. But rising inflation causes the stock market to go up and the U.S. Dollar to go down. Hence these 2 assets can no longer be used in a “diversified” portfolio because they are essentially the same trade when inflation starts to rise.
Diversify between trading and investment strategies
This is something that I’m doing right now.
- I used to trade solely based on the Medium-Long Term Model. That model placed medium-long term trades for the S&P 500’s ETFs.
- I am now also using the Day Trading Model. These are short term trades that use a completely different strategy when compared to the Medium-Lon Term Model.
I generally suggest that beginner-intermediate traders stick to 1 trading strategy. Jumping around strategies is not a good idea unless you have a very clear understanding of your current strategies strengths and weaknesses.
Trading is hard enough as it is. You don’t want to put too much on your plate by trying multiple strategies at the same time. It’s easy to become confused between these strategies and to mix them up.
But seasoned traders should diversify between multiple trading strategies. They should trade part of their portfolio via Strategy A, part of their portfolio via Strategy B, part of their portfolio via Strategy C, etc. For example, it’s common for seasoned traders to put part of their money in a medium term strategy and part of their money in a short term strategy.
The trades made by these different strategies will have a low degree of correlation because THE REASON for putting on these trades is completely different.
- There is no real diversification if you’re just diversifying between assets. For example, let’s assume that you are long U.S. stocks and Canadian stocks because you think that the global economy is improving. When the global economy deteriorates, BOTH the U.S. stock market and Canadian stock market will go down.
- But if you go long U.S. stocks due to a fundamental strategy and go long Canadian stocks due to a technical strategy, your entry and exit points will have no correlation with each other. You will enter and exit each position at completely different times based on the buy/sell signals from their respective strategies.