I’ve always thought about diversification as the buy-and-holder’s game. As in, not applicable to me. It always struck me as a strategy for people holding only long positions… they want to be in several industries so that if one declines, it doesn’t pummel them too badly.
The way to build wealth fast for a trader is concentration. You are in the right place at the right time, with buckets of money. And if you’re wrong, you get out before taking a bath. No need to have some other stock balancing your loss for two hours. Right?
But, can diversification help across several trades? In other words, can trading several different stocks help lessen the impact of your system’s drawdowns in one stock? Here’s why I use my doomsday entry title again: I claim that the answer is at best “maybe.” Not very satisfying, is it?
Here’s why… Say I have a system with a positive expectancy, but occasional protracted drawdowns of, say, 35%. Now I start trading the system on two stocks. Does this help? Think of it like superposition of waves… depending on the phasing, the gains and losses could be flatter, or the gains and losses could be steeper. In other words, trading against two stocks could double the drawdown. And, I claim there’s no way for me to predict when or if this scenario would play out… if I could do that, I could use that information to avoid the drawdown altogether.
Ok, you say, but if you trade 10 stocks, surely some of them will be making money at any given time… I agree that it increases the probability that at least one stock is making money, but there’s always a chance that enough losing streaks coincide that you could do real damage to your account. (and of course in the worse case you have 10 times the original drawdown). But, won’t making sure your stocks are in different sectors, or otherwise not correlated help? I’d say it’s highly dependent on the system you’re using, but that generally speaking there’s no reason to expect that to help for fast-trading technical systems.
So, this is sounding a lot like the last post… you can make the catastrophic event less likely, but it can still happen, and it’s impossible to predict. Scary! Worse, I have actually seen it happen in my backtester. On one system, trading either IBM or AMGN alone produced okay results. Trading IBM and AMGN together crippled my account at one point. One of their drawdowns happened to coincide.
One way to combat this problem would be to segregate account funds so that, for instance, 5 stocks each get 20% of your account. But, for the type of systems I am trying to use and develop, this is not desireable. For one thing, lots of systems only trade a few times a year, so you could spend a lot of time 80% in cash this way. But, it does seem to give you the diversification advantages, with the worst case scenario being a drawdown about as deep as the one-stock case, but far less likely.
A second way to diversify would be trade multiple systems at once. Again, I claim that you must have no way of knowing that the two systems won’t decide to draw down at the same time. If you did, you could use that knowledge to avoid trading the drawdowns in the first place. But, just as one would imagine that trading several stocks makes a steep drawdown less likely, it seems obvious that multiple systems on multiple stocks are less likely to all underperform in concert.
So, other than making the drawndown less likely, is there anything we can do? How can we survive if the big crippling diversified drawdown does arrive? I don’t know. Here are two thoughts:
A) Take a break from trading when your balance declines too much? I’ve seen this advice, and in general, I respond NO WAY! If you are trading a system that you believe in, then you could be walking away from the winning streak that recovers your account. Only stop trading if you need to re-evaluate your systems, of if you feel that the human side of the trades is “off” (like if you think the stress of the drawdown is affecting your judgement or execution).
B) Another idea would be to siphon off some funds during winning streaks (in addition to what you already take for living expenses), for reserves. Then, if your account draws down under $25k, you add $5k to it and keep going. Assuming you are risking 2% of current equity, you will be trading somewhat small by this timeframe, which is good. Keep nursing it to $30k every time it hits $25k again, until the drawdown is over and your account recovers naturally via trading gains. That approach actually sounds pretty good to me, but then the natural question is “how big should that reserve be?” I imagine you could do some backtesting-type statistics and derive the likely worst-case scenario, but I haven’t tried to do this.
Any others?
May 21st, 2006 at 2:37 pm
Just wanted to add that, in the “nurse your account up to $30k until the drawdowns finally end” case, you’d have to lose 9 times in a row at 2% drawdowns before you’d have to put another $5k in.