Strategy Diversification – Higher Profits… Higher Risks ?

If you look into the Asirikuy website, one of the main objectives around my development of automated trading systems is to develop experts we can use to makeup a successful porftolio of long term profitable trading systems. Most traders – new and experienced – believe intuitively that adding several strategies to a portfolio will diminish risk in the sense that the possibility to attain significant draw down levels will be reduced. However, through my experience and analysis of portfolio diversification I have found that – although portfolio trading is great – great care must be taken in both the makeup of the systems and the evaluation of the actual risk levels used to avoid catastrophic loses due to a “massive” portfolio failure. During this post I want to talk a little bit about the things you must take into account when designing a portfolio and how risk must be carefully studied to come up with a reasonable “worst case” scenario.
Why is portfolio trading great ? Well, we all know that having all our eggs in one basket is not so good. When we use a single trading strategy we are exposed to several problems which can be avoided when many different strategies are used. For example, we are not subject to the “hard hand” of the market as when one of our strategies is unable to profit from its set market inefficiencies another one will most likely be able to. So in the end what we get is a diminishment in our market exposure without a reduction in our profitability since – in the end- we will reach the same profit levels on all systems as if we had if we had run them by themselves. There is also a very positive psychological effect of running portfolios in the sense that “someone” will be winning and you will have something good to look at almost all the time. A shield you won’t have if you have to endure the draw downs attained by a single trading system.

However, new traders generally take portfolio design too lightly. It is simply not a matter of putting all the systems you can within an account, put a very high risk level and hope for the best. No, it is not about that and that strategy usually leads to account wipeouts and other such problems. You need to make up your portfolio with a very clear plan and knowledge of what you will do when certain scenarios present themselves.

First of all, each separate system must have its OWN risk projections and its own worst case scenario (the point where the system has simply become to risky to continue trading). You need to know into how much draw down each system will go because each draw down will contribute to the overall loses of the account. Second – and most important – you need to calculate your portfolio risk accurately. To do this you need to calculate the sum of all the projected draw downs and have this as your worst-case portfolio scenario.

In the end each system will be able to reach twice its historically worst perfoming point (the worst case individual scenario) and the portfolio’s worst scenario will be the addition of all the system’s historical maximum risk levels. In the end, systems have a flexibility to reach higher than expected draw downs (which are likely going to happen in the future) and the portfolio will be able to reach larger than expected risk additions since its “worst point” is an addition of draw down. This in turn means that portfolios have a lower risk thresehold than the systems, mainly because they need to reduce risk through diversification -if this doesn’t happen – the portfolio is simply not working.

In the end doing this analysis will ensure that you have CLEAR targets for your risk and clear “stops” in your account’s loses (since you know when to stop individual systems or the whole portfolio). One of the most important things in trading is to have a plan and trading a portfolio with a previous risk analysis is VITAL for survival. Of course, making sure that each one of the systems used is long term profitable is also of extreme importance and something which will make the success of a trading portfolio much more likely. (for those of you who are Asirikuy members a video will be out this Sunday better explaining a lot about portfolio makeup and analysis).

If you would like to learn more about automated trading systems and how you too can build trading systems to achieve long term profitability please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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