Some Dangers of Correlation & Benefits of Diversification in Trading

Many traders and investors make the mistake of trading and investing only in equities. While the stock market is a very popular place for retail traders and investors to use for their capital it is not the only game in town. Equities are just one asset class. Stocks are the place to be when their are expectations of growing corporate earnings and the economy is in a growth phase with low interest rates. Over their history stocks have on average been up in ten year periods and have beaten most other asset classes overall in the long term but this is based on buy and hold not ‘trading’ and there are many times where stocks are not the place to be in 20% bear market corrections and the 10 year flat periods where you lose money and inflation eats up your buying power.

Money is made by capturing trends inside your trading/investing time frame. The better the entry and the longer the time frame the better chance of profits for most people. Stocks do not always trend, but there are usually trends somewhere if you expand your watch list, systems, and back-tests. Along with equities there is also the forex, futures, the bond market, and option contracts. The reason trend followers trade multiple markets is to give them a high probability of catching those out sized trends and create the big outlier profits. If you are only trading one market and it is not conducive to making you money with your system then you limit your possibilities and decrease your probabilities of success. Trading markets that are not correlated gives you a wider range of opportunities with different types of price action in each.

People that trade only stocks have a larger amount of correlation risk than they realize, especially if they are long only traders. Here is where they get into trouble: they are holding five stocks at the same time and the market gaps down, if they have stop losses in place and are risking 1% of their capital per stop and all five are triggered at the same time suddenly their whole account is down 5% in one day. If they are risking more of their capital than 1% or have more then five positions on at one time they can be severely hurt in a big stock market draw down.  If they were holding only one equity position, along with gold, oil, bonds, or a currency the odds are that they would not be hurt as these assets are generally not correlated and  it would be rare for all to go against the trader at once. Also holding both long positions and short positions can help diversify a portfolio and and lower correlation risk.

Don’t put all your capital in one basket, spread it around carefully with the right entries and exits. Trade small, be nimble, be open minded, and always risk little and be open to making a lot when the opportunity is there.