Trading Systems and Methods, 6th Edition

CHAPTER 24Diversification and Portfolio Allocation

It's not that I'm so smart, it's just that I stay with problems longer.

– Albert Einstein

The risk of trading in specific stocks, ETFs, futures markets, or most other assets can be substantially reduced by diversification and proper use of leverage. The object of diversification is to have the offsetting price movement reduce overall risk more than it reduces returns. Trading in more than one asset (with similar volatility) will always reduce total 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. An important discussion will be deciding how much to allocate to each asset. 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 in this chapter will be those used by analysts specializing in portfolio allocation and risk management. It is important to be able to speak the same language.

• Alpha, a measure of improvement above risk-free returns or the results of a benchmark. A positive alpha is a measure of being smarter. ...