Friday, May 29, 2009

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How You Should Use Diversification in Trading Stocks?

Diversification is not just about reducing risk as has been popular thought. As I explained earlier in The Myth of Diversion in Trading Stocks, it is not applied best by many traders. It in fact ruins them. Here I explore the right intent of diversification and also the right application.

stock trading: how to use diversificationImage Source

The generally known use of diversification of portfolio is across a spread of stocks. Many people diversify across a set of four to five stocks. Some traders do within their comfort limit and some beyond that limit. Some traders and even institutional investors alike go to the extent of diversifying across as many stocks as 30 to 70.

Many noted mutual funds from fund houses like HDFC Mutual Fund, ICICI Prudential, DSP Merril Lynch (now name changed to DSP BlackRock) Mutual funds etc., all diversify to show the kind of effort they put in managing those funds. I don’t see any special value in doing so. But I believe it is the rule of the fund house not to scale a position too high into a single stock.

There is no such thing limiting on an individual trader. You can have your own limits. Why don’t you explore the best strategies for diversification?

The Right Intent of Diversification

The intent of diversification is not just about safety or reducing the risk of a bet. It is also about making things certain. Apart from making the risk more certain it also makes the profit more certain. This can mean that you can adjust your success rate by adjusting your bets going in a particular direction with diversification.

You can think of diversification from several dimensions. When you look at diversification from time perspective which is not generally known to every trader, your awareness about your long term trading increases. Raising awareness in any endeavor is very important. That will help do well consistently and focus on what really matters in your journey towards success.

The general diversification of portfolio too can be helpful in certain situations. When you follow a certain strategy to select your next stock (or your next good bets), you are sure that it will do well most of the time than other stocks. This works well because you are consciously using a strategy to filter out stocks that have potential for a move. To increase the success rate further you can diversify here with the best two stocks or best three stocks from the top of the list.

As explained above, knowing the right intent of diversification helps you become a consistently successful trader. The long term success of a trader is determined by consistency of good bets.

The Right Application of Time Diversification

Raise your awareness beyond a single bet and think of the way how different trades in succession can reduce the risk. If you look at only one trade you know there is only one chance for success or failure. If you look at multiple consecutive trades, you can see that even if the first trade goes wrong there is a chance for the second trade. The second trade or third trade and so on. The successive trade can either compensate the loss or the gain as well.

But the important thing to note here is that the time diversification also works for the same reason as the stock diversification. You may be thinking that if the first bet is loss then the next bet even if goes right, it may not fully compensate the first loss. Here it does look little different than a fixed weight diversification across stocks. But when you fix your allocation of capital for successive time periods then it will be the same thing as the other case. If your time horizon is for five successive trades, then allocate a capital as much as 70% of your portfolio for fixed capital trading on successive bets.

The advantage of this time diversification comes from the fact that it matches with the way the market behaves and also your trades rule based. When the market moves in one direction it continues to move in that successively for certain period of time. This successive nature will glue well with this technique.

When you can find trading entries based on a particular strategy and if the first one goes well, you will continue with the next. If the trend of the stock is intact, then the successive bets will go in your favor. Even if the last bet were to fail you will still have more profits than with the other diversification because you are allocating more than 50% of your capital on each of these successive bets.

Though it takes courage to allocate such an amount of capital, raising your awareness beyond the first bet and thinking of this time diversification technique will give that courage.

The other advantage of this type is that you can control the losses in a losing streak. As often the market continues its spiral of movement until it breaks the spiral after a certain point, it becomes clear. when one of your successive bets changes direction to make a loss. that the trend is changing. Here the important thing is to be willing to sacrifice the next bet as well to confirm the change in trend. You should be cautious after first failure. But you will be certain of the change in trend after another successive failure. This is because the trend’s change is not confirmed unless it happens in atleast two successive events.

From your first failed bet you can be cautious and reduce the capital for the next bet which is for test purpose only. If the trend change is confirmed you will reverse your strategy to go short if you were going long earlier. Otherwise you will continue with the trend.

If it happens that the market appears to play games with you by making fail-pass-fail-pass pattern, you should take the lesson that market went into a swing mode. Generally this is the classic case of range trading. This time you should change your trading strategy to suit this type of market. Here you should also increase your awareness beyond the successive bets into market trends and cycles.

The Right Application of Stock Diversification

This is how I apply this concept to my trading. I often follow a strategy to select stocks based on certain criteria. This is generally after checking the market statistics where stocks making new highs, new lows, top gainers, top losers, concurrent gainers or losers etc. are listed in order.

I may select any type of strategy I know well at any point of time. But when betting, I pick up more than one stock from the same criteria. If I pickup a stock which I feel will go up, then I can pickup another one that will do the same but with lesser chance. So I bet on both at the same time.

This will increase the chances of atleast one bet going right. As I use stop-loss the other one, if goes wrong, will be limited in loss. This of course also works to reduce the chances of atleast one bet going right. So I will now have a lesser profit than what I would have had if I had bet whole amount on a single stock. But the certainty of the bet going right is increased.

I also find this more successful because the choice of both the stocks is not random. Both are selected from the same criteria. The failure probability can be only because of any unexpected events implying very less failure rate. But the chance of atleast one going right is almost certain as they are picked only for that reason. And this coupled with a stop-loss is what makes it a wonderful strategy to consistently play with!

This had worked very well with my trading and it is one of my powerful and simple strategies. But I too forgot this sometimes. By noting down in the checklist this will not be a problem.

Start Applying in Your Trading…

I believe it will help you as well to apply diversification in your trading from these new dimensions. So don’t go about myths even when experts speak out. Analyze, understand and apply diversification in the right sense.

1 comment:

A J A Y said...

Hi Narender... its nice to see dat u r educating evry1 with a valuable trading secrets thru ur posts... Till nw am not into dis stocks business as I dont hav a much intrest into it also dont hav awareness of it, even though I hav an entusiasm 2 kno abt it... nw I found a best place to educate myself to enter into stocks in a better way... keep going man will follow ur way :)