A diversified approach is important in any investment strategy. There are varying levels of diversity from Macro to Micro levels. It is commonly accepted that using a combination of property, stocks and cash is a sound diversification strategy on a macro level.
At an equity market level, and especially for longer-term investments, diversification typically means holding stocks from different sectors and different countries. However, often new traders are not conscious of the dangers of ignoring a diversified approach at a trading level.
An example of where this becomes an issue is as follows: a trader looks through the ASX 200 or S&P 500 each day and takes 1 trade a day as they find them over the course of a week. At the end of the week all 5 trades are still open. The problem is that every trade is a bearish one. They are now very much exposed to a risk of upside movement in the market as a whole. Once more, the portfolio of trades has been built without any regard for the overall directional bias it creates and with no view on the market overall.
Of course it is ok to build up a large bullish or bearish directional bias based on a clear and strong directional view. It is not ok when there is a distinct lack of view of market direction. Imagine the above example occurred during either mid-March or mid-July of last year. Below Chart 1 highlights the moves that followed these periods. I’m sure you can picture the outcome!
Chart 1 – ASX 200 and S&P 500 2009 Rallies
click to enlarge
A worse approach still is to infrequently dive into large numbers of trades over short periods of time – opening 10 trades in a few days and then doing nothing for a few months, before opening another 10 again. Not only is the fate of all the trades potentially going to be quite similar, but it is hard to keep a clear perspective when analysing and managing them.
A better approach is to analyse every trade not only on its own merits, but also in regard to positions already held and an overall directional view. For the option traders out there, this is part of the same concept that professionals use when managing all the Greeks within a portfolio of option positions. In short, know the bias your portfolio has and ensure that the bias is intended.
Often this approach will mean keeping a ratio or balance of bullish and bearish trades at the same time.
This makes sense in the big picture as while markets will see the majority of their stocks moving with the major trend, there will always be exceptions.
With global terrorism becoming more and more of a potential ‘X Factor’ for markets, a balance also helps protect your trading account against such events. In many ways this form of diversification can also be referred to as hedging and can take the form of pairs trading for those familiar with the concept.
Now it is important to know when this approach is viable and when it isn’t. Buy and hold investors will not be concerned with short-term or often even medium-term movements and will simply see any falls as an opportunity to buy more. Obviously bearish positions are not typically needed in this case. On the flip side anyone who attempts to trade movements lasting hours, days, weeks or months can benefit from holding a combination of bullish and bearish positions most of the time.
Either way however, the concept of diversification remains the same. Look at what positions are already open and the overall bias your account has – sector, country or directional - before clicking the buy/sell button.