Even the best system experiences drawdowns, and as traders we’re worried about the irregularity of our returns. It’s tempting to cancel subscription when the fortune turns away from us but it may end up displeasing to see the missed profits when the system returns with a vengeance. And if has a solid mathematical expectation, chances are in its favor.
We touched this subject in another article, When a mechanical trading system is having a drawdown what do you do? This time let’s approach it from a different perspective. Portfolio diversification comes to help here as the natural tool of risk reduction. The idea is to add another, carefully chosen system to trade to smoothen our equity curve.
When properly applying this technique you can benefit from different systems responding differently to different market conditions or from trading different assets. Like with a portfolio of stocks, the idea is to choose another system that rises or falls at different times from your “primary” subscription.
Suppose you’re subscribed to ETF Pairs Arbitrage whose equity curve is underwater after making an all-time high in May:
A quick inspection of other systems’ equity curves on the “Find a Strategy” page suggests that there are other candidate systems still making money. Take Saltamontes, for instance. Its equity curve has been on a steady rise, with ups and downs spreaded differently from the “EPA”:
A choice of systems like this makes sense because they tend to support each other. What you have to care about is to avoid systems having a perfect negative correlation or it would be a zero sum game. If one system goes up 5% while the other loses 5%, there’s no benefit from diversification.
In this article there’s no room for discussion of complex concepts like correlation coefficients, covariance or efficient frontier. It’s a simple trading idea and should stay so. The takeaway is that it may be possible to achieve diversification through subscribing to loosely correlated systems to smooth out our returns.