Nº 3: Diversification Possibilities Within the Global Equity Indices Asset Class

All major stock indices are increasingly correlated due to globalization, limiting the options for spreading portfolio risk.

Most retail traders take the difficult route of heavy losses before learning the true value of portfolio diversification. Some never grasp the concept and as a result do not stay around for long. Concentrated risk with no exit strategy is the fundamental reason behind 90% traders losing 90% of their money within first 90 days - the so-called 90/90/90 rule.

As a trader, it is important to define your risk appetite. In other words, the maximum account draw-down you are willing to accept. This is vital for properly calculating the lot size of your trades. Moreover, these positions need to be segmented into various asset classes - stocks, indices, currency pairs, commodities, precious metals etc. It not only sets up the account for stability but also impacts trader's psyche in a positive way. This is because the maximum downside risk is known in case all active instruments move against the trader, which is fairly unlikely in a portfolio that has been appropriately diversified.

Ideally, there should be diversification even within an asset class because several trading instruments move in the same direction with almost the same strength. That is to say, a trader may be taking positions in different instruments for the purpose of spreading risk, but the objective will not be achieved if those instruments are highly correlated.

There are complicated algorithms available these days to manage risk. Such sophisticated software are mostly used by investment firms and hedge funds.

For retail traders though, simple statistical tools such as Covariance and Correlation Coefficient can be highly effective for creating a reasonably diversified exposure profile.

Traders and investors have traditionally used exposure in multiple indices to minimize their risk. These days, however, all major indices around the world seem to react in a similar way, predominantly due to listed companies having a larger, more globalized footprint.

To find out if there was any diversification possible in recent years by taking positions in various indices, I generated the covariance and correlation coefficient matrix below by using the daily close values of past three years of major Asian, European and American equity indices.

There was no surprise to see all the global indices having a positive covariance. I believe this has always been the case, though I haven't confirmed this as I was more interested in relatively recent data for my trading research purpose.

The correlation coefficient 'r' matrix revealed that all US indices are practically in-sync. This also made sense. In fact, it served as a check to see if I am calculating the 'r' values correctly.

Japan's Nikkie225 offered the most opportunities for diversification showing moderate to low-moderate correlation with the US and UK indices. The lowest 'r' value of 0.5 in the matrix was found for Nikkie225 and S&P500. Hong Kong's Hang Seng index was also a good candidate for moderate portfolio diversification when paired with S&P500 and DJIA. The US & European markets have generally been highly correlated, with maybe a minor exception of Euronext and S&P500.

I hope this conveys the idea of fundamental risk diversification and how to introduce it into your trading strategy. You can create more depth in your trading decisions by adding further instruments to your covariance and correlation coefficient research, exploring the affect of change in time-frames and so on. The grind will make sure that your trading strategy has a sound foundation.