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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