When to diversify winners?

[sef88]

Have different trading rules. Scale in and out of positions. That will give you smoother returns. In stats, there's always a distribution around the optimal parameter. Even if it's the optimal parameter, you wouldn't want to place all your faith in that single rule/parameter.

You can read Perry Kaufman materials on this.

 

[tomorton]

I'd be pretty sure that the value of diversification is an illusion if holding less than a couple of years. It certainly makes sense for investments over several decades but that's not what we're talking about.

I would suggest focusing on maximising return per stock, for example by pyramiding, before focusing on finding additional stocks.

 

[sef88]

If your stop is 5% away from your entry price and you have 3 positions you are risking about 1.5% of your capital per trade.

Diversifying hides your mistakes. You diversify so that your winners offset your losers. If you are taking losses quickly and letting your winners run you don't need diversification.

Mathematically, diversification among uncorrelated positions with positive expected returns will increase risk adjusted returns. With that you can always leverage up to boost your returns. That's what Ren Tech, Citadel do all day. We can take a page from that.

 

[Smart Money]

I think I get it. 5% divided by 3 positions. So I could cut it down to 1.25% by taking on a fourth position (5 / 4 ). I guess I should know what the risk is, but I've just always knew it was "small" relative to the gains and my account never seems to go backward unless we have one of those big market hiccups that bites all of us.

Thanks for the info. I'll work on refining my estimate of how much I can lose. (might not be 5%...could be 4% or 6%).

 

[Smart Money]

Mathematically, diversification among uncorrelated positions with positive expected returns will increase risk adjusted returns. With that you can always leverage up to boost your returns. That's what Ren Tech, Citadel do all day. We can take a page from that.

That's the interesting thing about leveraging or pyramiding up. It only works if you win. That being said, my perspective has always been that one only plays if they think they are going to win anyway, so it just brings you to the end of your journey faster (riches or a blow out).

I'm not using leverage now, and may consider it when I have a much longer track record. I will use leverage in the form of ETFs if the market turns bearish and I need instruments to play that go up when the market goes down. Lately though, there have been some obvious winners and market "darlings" even during down turns of the market.

 

[sef88]

That's the interesting thing about leveraging or pyramiding up. It only works if you win. That being said, my perspective has always been that one only plays if they think they are going to win anyway, so it just brings you to the end of your journey faster (riches or a blow out).

I'm not using leverage now, and may consider it when I have a much longer track record. I will use leverage in the form of ETFs if the market turns bearish and I need instruments to play that go up when the market goes down. Lately though, there have been some obvious winners and market "darlings" even during down turns of the market.

Monitor your portfolio volatility like a hawk and you would avoid risk of ruin.

 

[deaddog]

Mathematically, diversification among uncorrelated positions with positive expected returns will increase risk adjusted returns. With that you can always leverage up to boost your returns.

That sounds really good but what does it mean.

Try to explain it to me in simple language.

I understand uncorrelated positions One goes up the other goes down. Who cares if you get rid of the one that goes down.

Every trade you take should have a positive expected return. Why would you take one with a negative expected return.

Never did quite understand risk adjusted returns. Doesn't leverage increase your risk?

 

[sef88]

That sounds really good but what does it mean.

Try to explain it to me in simple language.

I understand uncorrelated positions One goes up the other goes down. Who cares if you get rid of the one that goes down.

Every trade you take should have a positive expected return. Why would you take one with a negative expected return.

Never did quite understand risk adjusted returns. Doesn't leverage increase your risk?

Let's say if you got 2 positions (pink and green) - the possible issue is you may not know which will go up or down at any point of time. When you merge the 2 returns stream, the ensuing returns stream in blue has low to minimal volatility because of the inverse correlation.

When you are able to engineer such a smooth returns with good risk adjusted characteristic (returns/volatility = Sharpe/ Sortino ratio), you can always lever up the blue line.

You can extrapolate this concept to multiple returns stream/ positions.

All of this is an abstract and you have to note that historical correlation/covariance matrix may change so you have to add additional filters.

 

[deaddog]

When you are able to engineer such a smooth returns with good risk adjusted characteristic (returns/volatility = Sharpe/ Sortino ratio), you can always lever up the blue line.

You can extrapolate this concept to multiple returns stream/ positions.

All of this is an abstract and you have to note that historical correlation/covariance matrix may change so you have to add additional filters.

This is way too complicated for me to wrap my head around.
I think I'll stick to buying stocks that I think will increase in price and culling them quickly when they don't.

 

[Smart Money]

That sounds really good but what does it mean.

Try to explain it to me in simple language.

I understand uncorrelated positions One goes up the other goes down. Who cares if you get rid of the one that goes down.

Every trade you take should have a positive expected return. Why would you take one with a negative expected return.

Never did quite understand risk adjusted returns. Doesn't leverage increase your risk?

I interpreted this as buying stocks or ETFs that are as different as possible from each other, and ideally not tightly correlated with the overall market. For example, I'll go ahead and tell you that one of my three holdings is the ETF, UCO, which is a 2X spot oil fund. It's only partially correlated to the stock market, so there is some protection there. When the S&P has a light/small down day, UCO may not. Anyway, that's one of the ways that I'm trying to diversify, but if I can't find good prospective investments that also have diversification, I will pick the better potential returns every time.

FWIW, would I recommend UCO? Not necessarily. I would have recommended it this morning, but moving forward, my charts will tell me if I should stay in it...so my opinion may change tomorrow. And I won't be discussing when to get out of it in this forum, so be careful out there.