There are thousands of trading and investing platforms available to analyze charts or company fundamentals. There is also no shortage of indicators to aid in timing entries and exits. However the mistake most market participants make is that as soon as they've found a stock which meets their requirements to buy (or short), they simply pull the trigger without any consideration of the positions they already hold in their portfolio. At first glance it may seem as though there is nothing wrong with doing this, however this actually results in higher risk portfolio's, wasted capital and missed opportunity.
Getting run over by the herd
The stock market is notorious for displaying herd like behavior. What this means is that at any given time, there are groups of stocks moving in similar patterns as a result of being highly correlated. There are a variety of reasons for this including fundamental, industry specific, economic and cyclic related factors. Ultimately your goal should be to gain broad exposure to the market without being over exposed to stocks that have a tendency to move together. This applies to all time frames regardless of whether you hold positions for days or years. Being over exposed to any single area of the market increases the likelihood that multiple positions will all result in losses simultaneously.
In more practical terms, lets say you are a technical trader who looks for pullbacks in stocks and today you find 5 stocks that all meet your entry criteria. You enter the positions and notice over the coming days that you are losing money on all 5 positions. You look through the charts and notice all 5 stocks are continuing their downward path in roughly the same manner. You are now sitting in a situation where you have tied up capital in 5 different positions and are losing money in all of them simultaneously.
The above scenario is exactly what you should be aiming to avoid by focusing on smart portfolio construction. Every new position should not only be analyzed alone, but also within the context of the positions you already hold. There are two things worth keeping in mind from the above scenario:
- If several stocks are setting up for an entry in the exact same manner at the same time, there is a high likelihood that those stocks are part of a 'herd' which have a history of moving in similar patterns. You need to perform the necessary analysis to confirm if this is in fact the case.
- If those stocks have a history of moving in similar patterns, then entering all 5 positions increases your portfolio risk and lowers your diversification. Just because you have entered multiple positions does not mean you have diversified your portfolio.
Smart portfolio construction
A far better approach would have been to only enter 1 of those 5 positions and then scan the stock market for 4 other positions in stocks which did not have any past relationship to the others. You could potentially still be looking for the same entry setups, however by framing those potential positions in the context of your portfolio, you are giving yourself a higher chance of being profitable across your portfolio as a whole.
This is not only a more efficient use of capital but it reduces your portfolio risk as a result of diversifying your trades across non correlated stocks. The result in this case would have still been a loss from 1 of the 5 trades, however you now have 4 other trades which have shown a historical tendency to move independently of the others. That makes 4 other opportunities to potentially be profitable.
This brings us to the question of 'What is DiversifyPortfolio and why should I care?'
Firstly, DiversifyPortfolio is completely web based and operates separately from your existing broker and trading platform. Therefore the tools can either be used purely for research purposes or to analyze potential positions and portfolio changes before making them in your actual account.
DiversifyPortfolio focuses on smart portfolio construction, not entry signals. Finding a reason to enter the market is only one part of a much bigger puzzle. When it's time to add positions to your portfolio, how do you decide which to choose? Blindly adding every stock to your portfolio that looks good and is setting up correctly is a recipe for disaster.
DiversifyPortfolio provides you with the necessary tools to analyze every position within the context of your portfolio as well as within the context of the market as a whole. We provide stock market scans, visualization tools, heatmaps, cluster charts and correlation statistics all specifically built with the goal of creating more profitable portfolio's.
The benefits (and practical applications) of diversification and smart portfolio construction are too numerous to discuss in this article, as are the tools offered by DiversifyPortfolio. Therefore we will be publishing regular articles that drill down into a variety of topics including:
- Understanding diversification and why it is important
- Understanding concepts like correlation and minimum portfolio correlation
- Portfolio allocation
- Opportunity cost
- How to get the most out of the DiversifyPortfolio tools
- Correlation clustering
- How to maximize an already profitable edge in a repeatable, efficient and scalable manner
Lastly, we will be publishing research and performance back tests showing how smart portfolio construction and diversification can increase your profitability in the stock market.
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