Diversification and Portfolio Allocation
The risk of trading in specific stocks, ETFs, futures markets, or most other assets can be substantially reduced by diversification and portfolio allocation. The object of finding the right amount to invest in each asset is to allow the offsetting price movement to reduce overall risk more than it reduces returns. Trading a diverse portfolio of assets will always have less risk than a single asset, which concentrates risk. For most investors, the best portfolio will yield the highest return-to-risk ratio in real trading.
This chapter discusses the methods that can be used to build a portfolio and maximize diversification. It begins with a simple, logical selection of markets, then shows how Excel's Solver 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 returns, as is the case for a long-only portfolio of stocks. The last part 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 management. It is important to be able to speak the same language.