The Importance Of Diversification (Part 2)

Continued From Part 1... 

More importantly, professional traders see the value in diversification, but not just in a superficial sense. We like to call it multi-faceted diversity. In layman's parlance, it is diversity across a trading or investing portfolio that is accomplished through a series of different strategies. This is a crucial aspect which a lot of retail traders and investors miss out on because they were never taught to think in such a direction.

From the get go, professionals are intently keen on only one performance metric: Risk-adjusted returns. As we stated in our previous edition, it does not matter how high gross returns are if risk is not measured and accounted for. Risk, or variance in a portfolio's returns is equally important as the headline performance metric because it takes into account the amount of quantifiable risk that a trader or investor was exposed to in order to generate the corresponding returns.

There is a term for this risk-adjusted return metric we are talking about. It is called the Sharpe Ratio. Without going into the technicalities of its derivation, the Sharpe Ratio measures the excess return of an investment or portfolio against the variance of said return and expresses this product as a ratio. The higher the Sharpe ratio, the more favorable the investment or portfolio is. A low sharpe ratio means the portfolio is exposed to a high level of volatility even after factoring in all marginal returns above a risk free money market instrument.

A good example that does a good job in cementing the concept of risk-adjusted returns is that of the Hedge Fund industry. There has been a good deal of talk about how the Hedge Fund industry as a whole underperforming the broad market (S&P 500 as a benchmark). Such talk is entirely misguided. As explained previously, the variance of Hedge Fund returns is generally much lower than that of equity returns (or whatever appropriate benchmark used for comparison). The risk-adjusted returns of Hedge Funds are therefore significantly superior to their benchmark indices, if we view the industry as a whole.

There is ample reason why the old caricature of an ailing Hedge Fund industry hasn't been slayed despite year after year of banter by punters who have little idea about their orations. While growth in the industry has long seen its heyday, Hedge Funds are certainly not a dying breed. In fact, there has never been more money sloshing around in the balance sheets of these funds since the 1980s; a quid pro quo in volatility times like we are now wadding in.

Comprehensive Diversification

Revisting the subject in the degree of diversification we talked about in Part 1, professionals understand that there is more than meets the superficial eye when mitigating and hedging risks in a trading and investing portfolio.  

Talk to any successful trader or portfolio manager and you will discover that they do not rely on a single strategy to generate consistent returns. Diversification to them also means spreading capital across various strategies that fall within their slated approach to the markets. This is extremely valuable, and is also one that most retail traders and investors tragically miss out.

This concept skips the part about diversifying across financial instruments and jumps straight to the point on qualifying a trade or position. We will give readers a couple of analogies to make understanding this crucial aspect a little lighter. 

Analog 1: Forex Trading  

Take Forex trading as an example. There are a myriad of approaches retail traders use to trade the world's largest market. There are technical approaches (chart reading), and there fundamental approaches (macro trading). In each of these subsets lies an almost infinite number of strategies.

For instance, a technical approach may consist of identifying momentum and trend trading, support and resistance trading, Fibonacci trading, Elliot Wave trading, pattern trading... The list extends perpetually.

Fundamental approaches may consist of global macro arbitraging, economic-linked trading, inter-market and correlation trading, value-price differentials, capital and current account , flow trading, monetary and financial balances...

Safe to say most retail traders involved in the Forex market embrace the technical approach much more than anything else. No surprise here. However, therein lies the rub; technical analysis is inherently retrospective. Charts are basically nothing more than past price action plotted under a set of parameters. Readers should not misinterpret this as "technical trading does not work", but rather "technical trading has its limits". We have spoken to many traders who fall within this category and they have proven that they can be profitable.

We are however looking through the lens of professional traders. The fact is that industry professionals almost never rely fully on the charts to generate consistent results. Their approach may be accurately called a hybrid of the known strategies in the trading and portfolio management universe.

Even when we limit our scope to the technical approach, the importance of diversity can easily been seen as a canary in a coal mine. Trending strategies simply do not perform positively in choppy market conditions. Momentum strategies are a liabilities in slow moving markets. Support and resistance strategies will not be optimal in strongly trending markets, just to name but a few. 

Not all strategies under the fundamental approach will work all the time. Much the contrary. In actuality, only a few select strategies will actually work the way they were planned to, depending on the market environment.

A trader that has his bearing fully set on a fundamental approach will need to regularity sustain relatively huge drawdowns on his equity because of the absence of precision in his entires. This will also be a detriment to the amount of leverage he can exercise on each position because of the potentially large drawdowns. 

Analog 2: Stock Investing

Portfolio management can take on many shapes and forms, investing being one of them. The nebulous universe of investing is not much different from trading is with regards to diversification in this aspect. Through the traditional lens, portfolio diversification means holding a basket of stocks spread across different industries to smooth out returns.

We take this one step further. There are many approaches to investing in publicly traded companies. Common approaches include the DCF approach is valuations (discounted cash flow), intrinsic value approach (traditional value investing), multiple expansion (growth), relative strength approach (within and across sectors), just to name a few.

An intelligent investor will follow the footsteps of the trained professional in his approach to diversification. Even before individual equity names are selected to be part of an investment portfolio, the approach towards qualifying these holdings should itself be diversified across different strategies.

As is with trading, no single strategy in the investment universe is evergreen. Believing that we foretell with consistent accuracy which strategies will fare optimally during each passing market cycle is a fools game that usually ends in tears. The path towards long term sustainability in the art and craft of investing lies in one's diversification across strategies that form a collective approach towards the markets. 

No Single Strategy Works Everytime

This is the gist of today's note. Diversification from the roots. If it is the strategies that define the trades and positions we have on our portfolios, then diversification should be applied to those strategies that we have in our approach.

Professional traders and portfolio managers understand and appreciate this principal. This is why a proprietary trading house has multiple trading desks, each of which are hosts to tens of individual traders whom themselves bear different approaches and strategies to trading the financial markets. An exemplary case of the multi-facetted diversification we talked about in the onset.

One of the keys to long term sustainability in the trading and portfolio management business is an adept grasp and confident mastery of different approaches to leapfrogging a common hurdle of generating superior risk-adjusted returns. The sooner the retail community understands and adopts this, the gentler their learning curve.

In summary: 

  1. Diversity is all around us, and is in our blood. Learn to love it! 
     
  2. A proper mindset anchored on consistency rather than reckless risk taking will catapult you to long term success in this business.
     
  3. Observe and learn how professional traders and portfolio managers think and act. There is a reason why most retail traders are unprofitable while most professional traders are.
     
  4. Diversify from the roots by developing your personalized set of approaches and strategies.
     
  5. Always keep tabs on the variance of your returns. Returns should always be placed in proper context to risk.