(Part 4 of ten-part series on Financial Truths)

Section 1: What Is Diversification, and How Do You Measure It?

Section 2: Determine Your Personal Risk Tolerance

Section 3: Set a Baseline Asset Allocation

Section 4: Define Ranges (Min/Max) Around Your Baseline Asset Allocation

Section 5: Trade and Invest, Staying Within the Ranges

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Section 1: What Is Diversification, and How Do You Measure It?

  • Diversification = Owning a variety of assets that are less than 100% correlated with one another
    • Every pair of assets has a correlation coefficient, a statistic (between -1 and +1) that measures how likely they are to move in the same direction over a given period of time
    • Example: A portion of the correlation matrix I use, calculated from historical data:
  • If the standard deviation (volatility) of your overall portfolio is significantly lower than the standard deviations of most of the individual assets inside it, you are well-diversified
  • Owning a few stocks in the same sector, or the S&P 500, isn’t enough diversification
  • For options (puts and calls), calculate the true underlying exposure (number of contracts * underlying share price * delta)

 

Section 2: Determine Your Personal Risk Tolerance

 

Section 3: Set a Baseline Asset Allocation

  • Map your investment universe
    • Long-term investors: use the short list of six major asset classes
    • Traders & active investors: use the longer list of asset subclasses, which includes the ten stock sectors
  • Start with your personal balance sheet (introduced in Episode 3); set Cash % = Cash Requirement / Total Assets
  • Divvy up the rest between stocks and bonds according to your age
  • Carve out a little for precious metals and commodities
  • Adjust up or down for long-term market conditions (prospective 6-14 years).  Learn how to make long-term forecasts here.
    • Traders & active investors: steer your stock allocation towards the sectors with the highest forecasted returns
    • Can use individual stocks, just make sure to account for the higher volatility

 

Section 4: Define Ranges (Min/Max) Around Your Baseline Asset Allocation

  • First, choose the following parameters:
    • Maximum permissible loss on a single position
    • Typical stop-loss
  • Calculate minimum and maximum in each asset class/subclass:
    • Max % = Max Permissible Loss Per Trading Position / (Asset SD * Stop-Loss Multiple)
    • Min % = (-1) * Max %, subject to any other restrictions on short positions
  • Make sure these allocations fit within your risk tolerance
    • Have us run your portfolio through our Trade Analytics Service – we do all these steps for you
    • If you want to do the math yourself: Estimate the expected return and standard deviation of returns, under different scenarios
    • Model with a lognormal probability distribution, and/or run a simulation
    • Sample:
    • Calculate the 1/N percentile of the loss distribution (the loss that occurs 1 in N years)
    • If greater than X, go back and change your baseline asset allocations until they fit within the risk tolerance you defined
  • Check out episode 10 for sample asset allocation ranges.  You’ll find a free, downloadable spreadsheet there.

 

Section 5: Trade and Invest, Staying Within the Ranges

 

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Find more episodes of the Torpedo Trading Podcast at this link