Diversification and Portfolio Allocation
The risk of trading in specific stocks, an exchange-traded fund (ETF), or individual futures markets can be substantially reduced by diversification and portfolio allocation. The object of finding the right amount to invest in each trade is to ultimately receive the highest return for the lowest risk. When a trading program shows profits in a broad set of diverse markets, then allocating part of the investment to more than one market will always improve the return-to-risk ratio.
This chapter discusses the methods that can be used to achieve diversification. It begins with a simple, logical selection of markets, then shows how the Excel's Solver program can provide a classic portfolio allocation solution with little effort. However, combining the return streams from trading results is not the same as using continuous prices, as done in traditional portfolio analysis. The remainder of this chapter shows how a genetic algorithm approach will create a portfolio that has a better return-to-risk ratio than the traditional solutions, and is flexible in the way it handles the idiosyncrasies of active trading.
Some of the terms used in this chapter will be those used by analysts working in the field of portfolio allocation and risk reduction. It is important to be able to speak the same language. These terms are:
Assets, which can be different markets, commodities, or investment vehicles.
Investment class, a category of investment, a ...