Using Diversification to Protect Against Black Swan Events
Many experienced traders will tell you that there is no such thing as a ‘holy grail’ in trading, but if there is indeed something like this, it should be diversification. If you successfully want to protect your trading account against the turmoil of the marketplace, there is no substitute for learning diversified portfolio theory.
Even today, there are still many traders who do not have a clear idea what the term diversification means and how to use it to protect their assets. Novice traders often use it incorrectly and end up compounding their risk instead of decreasing it.
Successful diversification is the part of portfolio management that deals with the balancing act of maximising returns while keeping risk at the lowest possible level. If you ‘diversify’ your portfolio in such a way that you reduce risk somewhat but also wipe out any possibility of a profit, that is certainly not an optimised diversification strategy.
The keyword here is ‘correlation’. If you are active in the Forex market and you want to decrease your risk levels, it makes no sense to ‘spread the risk’ by trading in five different currency pairs, all of which are quoted in terms of the US dollar. If something happens that negatively affects the Euro, it will often also negatively affect the GBP, the Swiss Franc and a whole basket of similar currencies.
The trick is therefore to diversify into markets that are negatively correlated, i.e. they do not have their drawdowns at the same time. If one of them experiences a sudden bear market, it is therefore very likely that the other one will experience a bull market at the same time.
Your portfolio should therefore be a mix of trading instruments from different markets. A successfully diversified portfolio could well include stocks, currencies, commodities, and bonds.
Fig 11.09(a) is a chart showing the relative performance of the USD Index compared to the Gold price since the 23rd of October 2011. This provides a simple illustration of what we are talking about here. Between the 25th and the 28th of October, the USD Index went into a declining phase. At the same time, the gold price experienced a strong bull run. When the USD Index reached its lowest point at -3.5%, Gold was up by nearly 4.5%.
Since the beginning of November, we have seen a similar trend emerge: the gold price has gained nearly 6 per cent so far, compensating for the rather lacklustre performance of the USD Index.
Of course, you do not want to be sucked into a bottomless pit. If the price of a trading instrument goes into a long-term declining phase, it should be dropped from your portfolio. This means you still have to trade with a stop loss, even in a diversified portfolio.
From time to time, it might also be necessary to rebalance your portfolio. As prices of individual trading instruments go up and down over time, the original percentage will be disturbed and you will have to buy or sell certain instruments to restore the balance.