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techniques essential trading strategies

BASIC

The Power of Diversification Stock prices don’t all move in the same direction at the same time, so diversifying a portfolio helps control risk By Michael Rechenthin

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espite what financial advisors say, perfect diversification doesn’t exist. Advisors might suggest a little big cap here, small cap there, international this and fixed income that. Then they wave a diversification wand and call upon the magic financial fairy to eliminate risk from the portfolio. All of this works well as long as the market keeps going up. When the market heads south, that fairy is nowhere to be found. Neither is that financial advisor. But investors who learn a few techniques can succeed no matter what direction the overall market takes. Real diversification doesn’t guarantee high rates of return—its purpose is to gain greater control of the risk in the portfolio through careful selection of uncorrelated products and the mechanical application of selling options. Diversification provides control of investments by treating them as a portfolio of correlated and uncorrelated positions. Let’s examine a simple portfolio of four symbols and then explore how using options can create positive cash flow each month. Take a look at a chart showing a portfolio of stock indices (see “Four portfolio stock indices,” right). While they’re all moving in (mostly) the

same direction, a slight amount of diversification is gained because the indices contain a large number of stocks and different allocations of components. Thus, the investor is dealing with “unsystematic risks,” which are specific to a company, industry or sector and can be reduced through diversification. But one can do better. Now take a look at a portfolio of

Four portfolio stock indices Take a look at a portfolio of stock indices.

the S&P 500, along with the addition of utilities, gold and bonds in “Adding elements,” below. Even though taking a long position in all of them, the positions don’t all move in the same direction all of the time. So, when equities decline, not all of the portfolio’s positions decline in value. Often during equity declines, gold and bonds increase in value as the market deems them

Adding elements Here is a portfolio of the S&P 500, along with the addition of utilities, gold and bonds.

june 2019 | luckbox

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