Why is Portfolio diversification critically important?

Portfolio Diversification

Another essential aspect of lowering your risk and maximizing your potential of profits is – diversifying your portfolio. It is always better not to bet only on a single strategy but to create a portfolio of strategies (or trades) that are not mutually correlated.

In other words, you have to understand how to create a diversified portfolio of uncorrelated strategies. So let’s start with the futures markets portfolio.

PORTFOLIO Trading with futures markets

The significant advantage of trading futures is that you can trade many uncorrelated markets to create a very well-diversified portfolio of strategies. We have a positive experience with these markets:

  •  Stock indices (e-mini S&P 500, E-mini S&P MidCap 400, E-mini Russell 2000, E-mini Dow Jones, NASDAQ)
  • Metals (Gold, Copper, Platinum, Palladium, Silver)
  • Energies (Crude Oil, Heating Oil, Natural Gas)
  • Bonds
  • Softs (Coffee)
  • Grains (Wheat, Corn, Soybean, Rough Rice)

One of the keys to successful trading and protecting your capital in the first place is to trade an uncorrelated portfolio of robust trading strategies.

There is one basic rule you should remember: “The more uncorrelated strategies are traded, the higher the probability that your trading results will be successful.”

What is correlation?

Correlation means a relationship between two variables: Correlation is something by which we can measure the relationship between two strategies by using their daily returns. This relationship is measured by a correlation coefficient, which can take values ​​from -1 to +1. To calculate the correlation between the two strategies, we use the Correlation Coefficient.

Figure 42: Graphical representation of correlation coefficient values of -1 to 1

In this figure, you can see the graphical representation of correlation coefficient values of -1 to 1. 

  • When the correlation coefficient value is equal to 1, there is a direct linear relationship between the variables.
  • When it is equal to 0, there is no relationship between the variables.
  • When it is equal to -1, there is an indirect linear relationship between the variables. As you can derive from this figure, the desired level of correlation between 2 or more strategies is 0.

If the correlation coefficient is 1, strategies behave the same way from the return or loss point of view, so there is a linear relationship between them. And from the risk management point of view, it is not good to trade those two strategies together. If the correlation coefficient equals -1, it means that one of your strategies will lose money; the second one will be profitable at the same time. So, one more time: the desired level of the correlation coefficient between two of the strategies should be close to 0. This way, you can lower your risk and maximize the profit potential. However, it is not about to trade only two strategies.

A well-diversified portfolio’s goal is to have no linear relationship; it means no correlation between their daily returns.

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