Diversification

I open here a new topic regarding Diversification further to Snapman's last post in the Eye of Sauros blog : Asset Portfolio diversification vs strategy Portfolio diversification

Snapman,
As a very first comment to your good post, I would say that I disagree with the media, what my broker and my financial adviser say, and even what my parents say about the Portfolio Diversification : my opinion is that it is for the birds.

As you mentioned, in the case of a systemic shock as we experienced in 2008, the correlation between all the asset classes tends to go to 1 (everything drops at the same time) making your well-diversified nest egg vulnerable. Now in the case of a market under "normal conditions", the Portfolio diversification just suffocates the good profits you make on your privileged asset class. In other words : by diversifying, you bear all the losses and limit the profits : that's just a profile you can't accept. I think that as money managers we need to focus on our expertise area, develop here an edge and deep knowledge and then go for the jugular when the time comes.

To illustrate and to come back to a previous discussion we had (i believe it was on the chat) regarding the S&P 500 versus the Dow Jones. Those two indices show a very high correlation meaning that they move in the same way most of the times. My point is that it is much easier to master all the parameters, data, economic releases, fundamentals of the 30 names of the Dow (actually 10 names are representative of the whole) than the 500 of the S&P. That's exactly the same thing with having a diversified portfolio vs a concentrated one :
- it is easier to identify 30 names that are unlikely to go bankrupt rather than 500
- it is easier to identify a couple of names likely to outperform rather than 100

The point you raised on the strategy diversification is very interesting too and I will discuss it later, it's getting late here and tomorrow will be a great trading day!

Thank you for your kind comments.

About your Dow Jones argument:

I can see why one would wish to trade the dow for simplicity especially during times of high correlations. It is often why people who start learning about prop trading my be drawn to technical analysis more so vs the arduous task of learning fundamentals.

Well either way, if your strategy and style are working for that is what counts. But It is possible to get an idea of the general trend of the S&P by focusing on the most relevant sectors and equities that may move the index. One does not have to outright know all 500 stocks (though I do know some people who can do this).

For me I prefer to be a bit more thorough and have a better representation of equities from all sectors that are affected domestically and abroad that gives key insights at times, where the dow is limited to a good majority of domestically affected stocks.

Broad representation of the stock market is much better in the S&P500 in my opinion and there for more meaningful conclusions can be made.

However, if you are just looking to trade aggregates and correlations, I can see why the dow is attractive.

I look forward to reading your next post...

-snapman

Hi your sector argument is valid, point taken, and I agree that only a few names move the indices, roughly 50 names of the S&P500 but that's only 10 names for the Dow and I need to look more closely but I guess those 10 are in the S&P500. Doing some maths now on the correlation Dow-S&P500, I will let you know if anything relevant comes out

beside HRA is there any other analysis you are doing on BBG? i would be most interested in learning!

-snapman

HRA is quite good for those "lucky" enough to have Bloomberg.
Else if you want to push further (or if you don't have bloomberg) there's still the old good Excel.
To be honest, I've met hundreds of professional traders, all had access to million dollars softwares but at the end of the day, all of them use (and rely on) Excel...

I was interested in what kinda Math and methods you are doing to calculate the dow/spx

My latest post, Dow Jones 100,000 by 2012 or maybe 1,000 I'm not sure deals to a large extent with the fallacy of the diversification

Snapman wrote:

I was interested in what kinda Math and methods you are doing to calculate the dow/spx

The panel of mathematical, Econometrics and statistics, to study correlation is very wide. I've not used it on my own for a while but in addition to statistical correlations, regression, scatter plots you find on bloomberg that are pretty good, you could for instance consider a study (I can't remember the name of the indicator) to see whether the Dow or the S&P is leading, the sensitivity of the earnings of each name to the index, sectorial sensitivity, etc etc . I need to find time (and hands to help me) to come up with a study but i can't promise anything as it could be cumbersome. The idea is to assess a long S&P500-short Dow strategy. The thing is there are zillions of guys already profiting from the difference, and we'll need to take the money from their skilled hands.
This being said, if I find something really relevant I will keep it for ME

Sauros wrote:

Snapman wrote:

I was interested in what kinda Math and methods you are doing to calculate the dow/spx

The panel of mathematical, Econometrics and statistics, to study correlation is very wide. I've not used it on my own for a while but in addition to statistical correlations, regression, scatter plots you find on bloomberg that are pretty good, you could for instance consider a study (I can't remember the name of the indicator) to see whether the Dow or the S&P is leading, the sensitivity of the earnings of each name to the index, sectorial sensitivity, etc etc . I need to find time (and hands to help me) to come up with a study but i can't promise anything as it could be cumbersome. The idea is to assess a long S&P500-short Dow strategy. The thing is there are zillions of guys already profiting from the difference, and we'll need to take the money from their skilled hands.
This being said, if I find something really relevant I will keep it for ME

-_-