SPA3 and trading diversification

While many believe that diversification means to select stocks in various sectors and various markets, this tenet of modern portfolio theory (MPT) has its drawbacks.

1. This assumes that large portions of entire portfolios cannot be withdrawn from the market in a short time span (a few days).
2. Returns can be sub par as they will close match index performance
3. All stocks tend to have a high correlation during bear markets meaning that diversification is limited in reducing drawdown.
4. MPT does not allow for the scenario of creating a portfolio where entering and exiting positions in the market is done according to a consistent methodology and has integrated timing, risk management and money management rules.

This is why exposure to the stock market is best done with a trading system, either developed or purchased (SPA3).

When using a long only system to trade markets, it is inevitable that periods of drawdown will occur. The amount of drawdown you suffer will be based on how you manage risk in the market. If the market is dropping, the risk to enter long positions is HIGH meaning you can do a number of things:

• Close all positions until market returns to low risk
• Ignore market risk completely
• Sell 1/3 of all open positions immediately
• Sell 1/3 of open positions that are in overbought territory according to a momentum indicator of your choice
• Hold all Low Risk positions open and close all Medium and High risk positions

There are various approaches but the best (in terms of providing the smoothest equity curve overall) is to use a method of diversifying trading systems rather than to manage risk within the one market. Diversification for a trader means being able to switch systems on and off, or move various amounts of money between each to suit current market conditions.

Eg. Run long-only system on the ASX provided market is in low risk, and when market turns to high risk lighten all positions by 1/2. This then gives you back 1/2 of your money to use in a different system, such as a daily index system to trade the short side of a falling index. Once market risk returns to low this money can then be moved back into your long system and even leveraged to increase return.

This should reduce drawdown and mean that your equity curve is only being added to by systems that are trading with the predominant trend.

SPA3 research has shown that if you take a conservative risk profile and close all your positions immediately upon a high risk market, the overall returns are a lower than if you simply lighten and keep your money invested. This is true for bull markets (obviously) and even slightly sideways or negative markets, but not when the index drops 30-50% as it has done in 2008. During this time, a more conservative risk profile would have kept a trader in cash the whole year and saved them from serious drawdown.

Dealing with this in the future can be done in two ways. Either run diversified trading systems with a conservative risk profile in each to ensure that money is being used on the predominant trend, or to continue to trade long-only but with a hedge. There is an argument that a hedge simply retains the status quo and eats up brokerage, but if a trader has not developed more than one system to trade with any cannot rely on system diversification then hedging is a good way of keeping positions open but reducing drawdown.