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Five Requirements of trading

Posted by Bloglovers on December 31, 2011

Taking large, concentrated positions is extremely risky. Granted, if you take the right side of a trade, large positions generate incredible gains. However, guess wrong and your capital is eliminated. No one can always be on the right side of the market, so the goal should be to protect capital and have the ability to invest in the future.

To mange this risk, most investors diversify their portfolios. Although diversification makes sense, it also causes confusion. The main problem with determining an asset allocation strategy is that during times of crisis, correlations merge and what was thought of as a well-diversified portfolio shows its true risk. Any investor who bought different mutual funds for diversification and discovered that all the managers held similar stocks can relate to this experience.

Harry Markowitz earned the Nobel Prize for his work that led to the Modern Portfolio Theory (MPT). As the background for diversification, MPT offers a model to build a portfolio. However, before doing some math and settling on a strategy, you should familiarize yourself with the five main rules of MPT. They are:

  1. Number of securities – When you expand the number of securities in your portfolio, risk drops and expected return increases. However, there are limits to this strategy. Academic studies show that once you reach thirty different items, further risk reduction is eliminated.
  2. Covariance rules – Most investors look at individual securities to determine risk. Within a portfolio the important factor is not the riskiness of individual names, but how these stocks react to one another. If you have two stocks that are extremely risky, but move in opposite directions on a daily basis, a portfolio with fifty percent of your money in each would be very safe. Look past individual risk and focus on total portfolio risk.
  3. Efficient Frontier – The efficient frontier is the combination of assets that offers the highest expected return for a given risk level. All portfolios must reside on this point. Select a risk profile and then see what portfolio will do best. Any other choice is suboptimal and should be avoided.
  4. Volatility – MPT is based on a risk/reward tradeoff. Using volatility as a proxy for risk, the formula is sensitive to this input. A volatility assumption that dramatically differs from what actually occurs leads to unexpected outcomes.
  5. Looking forward – MPT is sensitive to your data inputs. Investors who properly gauge future volatility and the resulting covariance between securities will have an optimal portfolio. While we must look to the past for guidance, the important factor is what occurs in the future.

MPT offers an excellent method for building, monitoring, and managing portfolios. Understand the five main rules of MPT and you will see risk reduced and gains increased, and avoid unexpected negative surprises.

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