Portfolio Diversification
Overview
Portfolio diversification reduces risk by spreading capital across multiple uncorrelated or negatively correlated assets, strategies, and timeframes. True diversification requires correlation analysis — holding 10 tech stocks is not diversified. The goal is to generate returns from multiple independent sources rather than relying on a single trade or strategy.
Key Concepts
Asset class diversification: equities, bonds, commodities, crypto, real estate. Strategy diversification: trend-following, mean-reversion, carry, momentum. Timeframe diversification: intraday, swing, position trading. Geographic diversification: US, European, Asian markets. Correlation analysis: measure how assets move together.
Entry Signals
Allocate capital across 3-5 uncorrelated strategies. No single position should exceed 5-10% of total portfolio. Rebalance when allocations drift by more than 25% from target. Include both long and short strategies for true hedging.
Exit Signals
If one asset class dominates portfolio P&L (either direction), rebalance. Review correlations quarterly — correlations change during crises. Reduce exposure to asset classes exhibiting increased correlation during stress.
Best Timeframes
Portfolio-level decision — applies to the overall trading business
Pro Tips
Diversification reduces returns during optimal conditions for a single strategy, but dramatically improves risk-adjusted returns and survivability. During market crises, correlations often spike toward 1.0 — true diversification requires assets that change correlation behaviour.
More Topics in This Category
Correlation-Aware Allocation
Correlation-aware allocation goes beyond simple diversification by mathematically measuring how assets move together and sizing positions accordingly. Two highly correlated positions (e.g., ES and NQ) effectively concentrate risk. By adjusting allocation based on measured correlations, traders build portfolios with better risk-adjusted returns.
Fixed-Fractional Position Sizing
Fixed-fractional position sizing risks a fixed percentage of your account on every trade (commonly 1-2%). This ensures that a string of losses reduces position sizes proportionally, protecting capital during drawdowns. It's the most widely recommended position sizing method for discretionary traders because it's simple, sustainable, and mathematically sound.
Kelly Criterion
The Kelly Criterion is a mathematical formula for determining the optimal bet size to maximise long-term growth rate. Kelly = (bp - q) / b, where b = odds received, p = probability of winning, q = probability of losing. While theoretically optimal, full Kelly is too aggressive for most traders — half-Kelly or quarter-Kelly is more practical.
Maximum Drawdown Limits
A maximum drawdown limit is a predefined loss threshold that triggers mandatory action — reducing size, stopping trading, or reviewing strategy. Common limits: daily max loss (e.g., 3%), weekly max loss (e.g., 5%), monthly max loss (e.g., 10%), and total max drawdown (e.g., 20%). Professional trading firms and prop firms enforce strict drawdown rules.