How to Enhance Returns and Limit Risk Through Diversification: By Justin Paolini

“From my earlier falilures, I knew that no matter how confident I was in making any one bet I could still be wrong – and that proper diversification was the key to reducing risks without reducing returns. If I could build a portfolio filled with high quality return streams that were properly diversified, I could offer clients an overall portfolio return much more consistent and reliable than what the could get elsewhere” – Ray Dalio, Principles

Most aspiring traders spend way too much time attempting to perfect 1 method. Even worse than that, most traders tend to use 1 trading strategy for all markets, acting like a man armed only with a hammer that sees everything as a nail.

This happens to the best of us unfortunately: when the going gets tough, and we get into drawdowns, the mind starts to think of what went wrong and how to “fix” things. At FXRenew we faced our most difficult period last year and we too spent time reviewing our trading model. It’s just a natural thing to do and perhaps there are some things that require adjustments now & again.

However, our enhanced performance was not actually due to the model being “broken”. We were just viewing all markets like “nails” and asked the system to deal with situations that it is not suited for. This might be an issue you are facing as well.

The real solution is to diversify – create alternative models exploiting alternative edges. Here’s how we did it.

How to Diversify Effectively

“My goal is that I want to trade more than 15 uncorrelated assets.” – Ray Dalio

In order to exit our drawdown phase, what we did with the London Open Signals was eventually strip things back to the basics:

  • what is our model designed for?
  • what environments is it meant to operate best in?

So we ended up making a decision to trade less, but only trade when the conditions were absolutely clear (for the model in place).

On the other hand, we got to work on different models that would address some of the opportunities we “thought” we could exploit – just that the London Open model wasn’t suitable. We needed to diversify away from the classic short to medium term trend-following approach.

A quick note on diversification. Many people think that, in order to diversify, you just need to put 2 things together that are negatively correlated. There’s truth to this statement but we need to clarify if further. We’ve spoken before about correlation and noted that depending on the underlying drivers, correlations can (and do) change.

Source: TradingView

The chart above illustrates Gold vs. US Bond futures. Typically, gold and bonds should be inversely related because inflation will be bullish for gold and negative for bonds (because higher inflation normally implies higher interest rates). However, when central bank easing (or outright deflation fears) kicks in, both gold and bonds can move higher together, as interest rates drop (i.e. bond prices rise), while easy money expectations will possibly bring about a currency depreciation, which will increase gold prices.

Dalio said “correlation does not imply causation”. What this means is that each market behaves logically based on its own determinants, and as the nature of those determinants changes, what we call correlation changes.

So true diversification comes not from astute mathematics, but from a comprehension of fundamental drivers. As drivers change, correlation changes.

Alpha Diversification

When speaking about Alpha (ergo: active trading rules that deviate from passive indexing) and diversification, the key is to craft models that exploit different edges.  And that is precisely what we ended up doing. Both new models we implemented exploit much different scenarios compared to the London Open model.

  • The Newsflow model capitalizes on key market moving events that, in some fashion, catch the market off-guard. The ensuing shift in participants’ expectations can offer very attractive returns compared to the risk outlay.
  • The End Of Day model is itself internally diversified as it deploys separate rules for at least 4 different market types. Additionally, it works on longer horizons than our other models.

Together as a single portfolio, the 3 models greatly diminish total volatility whilst smoothing (but not compromizing) the return curve. That’s the beauty of true diversification.

Over to You

Of course, each trading model needs to have a solid edge on it’s own. Diversification cannot overcome incompetence. If you mix a winning system with a losing system, the results won’t be satisfactory.

The lesson here is that the Holy Grail of trading (if there ever was one) is to find multiple trading rules that exploit specific market conditions “fairly well”. The models should be simple and effective. Each model will go through it’s own ups & downs and that can be taxing on the mind if you’re only operating that one model (for example, a trend following model might remain flat for an entire week or two at times).

However, combining the models together provides more opportunity but at the same time insulates you against loss because (hopefully) not all models will break down at the same time.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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