Combining Two Styles of Portfolio Diversification
Combining Two Styles of Portfolio Diversification
Layering strategic diversification atop asset diversification can safeguard your holdings
- Traditional diversification in the financial markets is asset diversification, where you split your investments across different asset classes.
- But another way to diversify can have an even greater impact on your portfolio. It’s called strategic diversification, and it’s where you deploy different strategies inside your portfolio.
- By using both asset diversification and strategic diversification, you can create a portfolio that minimizes overall risk in different ways, on a macro as well as a micro level.
Asset diversification
Traditionally, diversification is thought of only as asset diversification. You don’t have all of your investable assets in equities alone. Instead, you split your capital across various asset classes, such as equities, fixed income, precious metals or cryptocurrencies. As different asset classes typically respond differently to how the market digests information and responds to macro-level events, having exposure to these different investments should theoretically do a decent job of shielding your capital from being clustered together during a huge market drop.
But in the world of diversification, your efforts don’t have to stop at asset-only diversification. You can also consider strategic diversification.
Strategic diversification
Besides employing asset diversification, you can apply a completely independent form of diversification to your portfolio—strategic diversification. By deploying various strategies in the market, each with its own set of features and characteristics, you can build a portfolio primed to handle a myriad of market conditions. For instance, by selling premium when implied volatility rank is high, you are building positions that will benefit from any volatility mean reversion in that single stock, or even any volatility contraction in the overall market. Similarly, while holding those short premium positions, you can add long premium positions in other stocks that have experienced a dip in volatility. This allows you to play the same volatility mean reversion from the other side, while now benefiting from any volatility expansions that hit the market.
So not only can you create a portfolio with the more traditional approach of asset diversification, but you can also layer on top of that an element of strategic diversification, too. Asset diversification covers your portfolio in a more macro sense, while strategic diversification offers up a more micro approach to risk reduction. Using both gives you coverage across the board in the market from several angles, each contributing to diversification’s chief objective of risk mitigation in its own way.
Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3
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