The Power of System Diversification

Are You Diversified?
Investopedia describes diversification as “A risk management technique that mixes a wide variety of investments within a portfolio” that “strives to smooth out unsystematic risk events” “so that the positive performance of some investments will neutralize the negative performance of others.”

I personally think of it as the process of combining multiple non-correlated strategies together in an effort to smooth out your long term equity curve. Every strategy has a weakness somewhere and will have a bad hair day, month, or even year from time to time depending on market conditions.

Once you begin to accept and even embrace this fact your probability of long term success increases dramatically. If you allocate the majority or all of your funds to a single strategy because of past performance or any other reason you will likely struggle to be successful over the long term because of the human tendency to not stick with something as soon as a drawdown of almost any size occurs.

Unfortunately, the majority of investors discovered in 2008 that the traditional diversification model pitched by most of the financial industry failed miserably as correlation among most asset classes rose to historic levels. There is an old Wall Street adage that says “the only thing that goes up in a down market is correlation.”

Experience has taught me to define success by having a well-defined and diversified plan that I execute with rigid discipline and flexible expectations for the month by month outcomes. Here are a few bullet points in my personal trading plan that I like to review on a regular basis to maintain a healthy and realistic mindset of MY personal beliefs about the markets.
• The markets are capable of anything. Expect the unexpected. Without risk there is no reward.
• Losses are ok and they are part of the plan. My focus is flawless plan execution and respecting stops/max loss. This is what creates discipline and confidence. The objective is to make money, not to be “right” on every investment or every trade.
• There is no holy grail. There will be drawdowns, losing trades, and losing months. Focus on execution and long term results and even the tough times can be low stress. Nothing works 100% of the time.
• When monitoring open trades focus on plan execution, not current P/L. Professional traders feel pressure when a trade is going against them, amateurs impulsively act on it.
• Executing my plan is boring and monotonous. Ignore the noise and impulse of everything else. Patiently wait for my setups to occur and my adjustment points to be hit.
• Emotions are real, so be aware of them. The person screaming at the computer will be the guy on the other side of my trade if I’m flawlessly executing my plan on a daily basis.
• Nobody knows exactly what the markets will do next. Stay disciplined and focus on risk management and execution.
• Seeing the next big move coming is always easy in hindsight. For this reason I will always have long puts on to protect the extreme outlier downside Delta and Vega risk.
The additional benefit of diversification is that when your portfolio isn’t overly dependent on the performance of any particular strategy you will have a chance at actually sticking with that strategy WHEN its next drawdown occurs instead of being part of the mob of performance chasers out there who become a statistic in the next Dalbar study. Analyzing individual strategies as “better or worse” based on something like a few recent months or years of past out or under-performance is often missing the big picture. Nobody knows what market conditions might occur in the near future that could be optimal for one strategy while more challenging for another. But blending together multiple non-correlated strategies gives your portfolio the highest probabilities of providing long term satisfactory performance with acceptable drawdowns.

Kim Klaiman is a full time options trader and has been trading stocks and options for more than 10 years. Kim is a founder of educational blog and forum He likes to trade a variety of non-directional trades with low correlation to limit the total portfolio risk.

Kim Klaiman
Founder and Editor
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