How To Build A Diversified Portfolio Of Trading Strategies (Why You Need It As A Trader) – [Two Examples]

A portfolio of trading strategies

You need to build a portfolio of trading strategies that differ in markets, time frames, and types. Why? Because you want to have a portfolio of trading strategies that both complement each other and make the portfolio diversified and uncorrelated. In order to do this, you preferably need to test and simulate on a trading platform.

The most important task of a quantitative trader is to find trading edges and subsequently turn them into good stand-alone strategies. However, many traders neglect to test how those strategies perform together as a portfolio of strategies. Just as a long-term investment manager puts together a portfolio of stocks, a short-term trader needs to evaluate how the strategies perform together as a portfolio.

An investor doesn’t compose a portfolio or basket of only oil stocks. The investor looks for stocks that both diversify the portfolio and complement it. A trader needs to have the same mentality.

It’s impossible to predict the future value of a stock, and likewise, it’s impossible to know the future predictive power of a quantified trading strategy. This is the reason why you want to have a portfolio of many strategies.

Some strategies will gradually deteriorate, some might blow off spectacularly, and others perhaps perform much better. You need to diversify your strategies just as you diversify your stock holdings.

Perhaps you need ideas for strategy development?

Before you continue reading we want to make sure are familiar with our database of both free and paid services:

Why is the composition of the trading strategies important?

Five individual trading strategies that perform well on their own, might not complement each other well. There could be several reasons for that, like for example:

  • You have overlapping trades in the same instrument/asset class.
  • The strategies might correlate too much.
  • Strategies in the same instrument might not overlap, but the winning trades might overlap a bit, making the average gain substantially less.
  • The type of strategies is too similar.

Why you shouldn’t spend too much time on one trading strategy

We know many traders who spend literally years fine-tuning just one or a few strategies. They are trying to hit the jackpot by adding more variables or filters for their quant strategies. But we believe this is a very bad idea. It’s a bad idea because:

  • You end up curve fitting the strategy to the past and lose predictive in the future.
  • All strategies, sooner or later end up arbed away or become victims of changed market behavior.

We believe in this: It’s better to have a portfolio of many sub-optimal trading strategies than one or a few “perfect” strategies.

Why have a portfolio of strategies?

The most important factor in quantified trading is having unrelated strategies, ie. strategies that don’t correlate with each other. That is of course no easy task and requires a lot of work.

For example, finding strategies that don’t correlate among stocks is next to impossible. Stocks move up and down mostly in tandem and thus trading a mean-reverting strategy on a basket of stocks gives many signals at the same time. You need to diversify away from stocks to avoid this.

Another obstacle is that during panics the correlation among all asset classes increases. During a short-term panic, as we saw during the GFC in 2008/09 and the Covid-19 in March 2020, everything is sold down except Treasuries and some select commodities.

The good thing is, if there is a long-term bear market, like we saw during 2000-2003, the correlations are much weaker.

How can you make uncorrelated strategies?

You need to look at different factors to differentiate your strategies:

Trade different asset classes and markets

The best way is to look at different markets. Commodities, for example, often go the opposite way of stocks. Thus, one of the first things you should do is to look at different markets.

Make sure you trade different time frames

Trading different time frames in trading can also be helpful. Day trading, for example, should not correlate much to the overall trend of the market.

Trading books like to mention you should always go with the underlying trend, but much of this is nonsense and never tested in any quantitative way. The fact is that longs could be fantastic for short-term gains in a bear market – it all depends on the time frame:

Did you know that the most powerful up days come in a bear market? Please see the stats we provided in the link above about the anatomy of a bear market.

Type of strategies: Mean-reverting, trend-following, or momentum?

Mean-reversion means a move either up or down is followed by a move in the opposite direction. Stocks are typical very mean-reverting in the short term.