At the 25th anniversary of the crude oil contract on the NYMEX, Paul Tudor Jones ( http://en.wikipedia.org/wiki/Paul_Tudor_Jones ) gave a presentation where he described how he categorizes trading strategies. Here they are with some examples...
1) Specialized knowledge of an Instrument
Stock picking long/short (research analysts)
Floor traders (back in the day)
2) Arbitrage (take advantage of pricing inefficiencies)
NYC vs. London, Cash vs. Futures
Pairs trading (statistical arbitrage or relative value)
Microstructure (Bid/Ask spreads) (HFT)
3) Trend (Momentum) Trading
Trin trading (day trading)
Nasdaq late 90’s
4) Execute at the “Peak of Human Emotions”
Small group of people (Idiot Savants) Exuberance vs Fear
Buffett “Be greedy when others are fearful and fearful when others are greedy”
This is a useful framework...if it's good enough for PTJ it works for me.
Harry Markowitz ( http://rady.ucsd.edu/faculty/directory/markowitz/ ) is credited with the comment that diversification is the only free lunch in investing.
Mathematically diversification is about UNCORRELATED movement of asset prices. There are many ways people tackle this including MPT, Post-MPT, risk-parity and others. I focus on the number .707. (I used it when designing microprocessor chips worrying about how many electrons I needed to get in place on time)
It is a VERY useful rule of thumb when combining assets with random returns (iid) that have LOW CORRELATION. Each time you DOUBLE the basket of assets the variance (standard deviation of returns) will be reduced by .707. For example...
- 1 Asset volatility N
- 2 Assets volatility ~.707 * N or 30% less
- 4 Assets volatility ~.707^2 * N or 50% less
- 8 Assets volatility ~707^3 * N or 65% less
- 16 Assets volatility ~.707^4 * N or 75% less
Notice the reduced bang for the buck. The reality is that it is VERY difficult to find 8 uncorrelated assets and getting harder with globalization (global equity markets have become more correlated the last 15 years). The biggies are Cash, Equities, Bonds, Real Estate, Absolute Return, Managed Commodities and Gold.
I don't like it when large funds claim higher diversification because they have small positions. This is usually driven by liquidity constraints rather than diversification optimization and pushes returns to the mean. Yes a bankrupt company is a RISK FACTOR that gets diluted with large positions but equities are equities. Buffett has said 10 and Cramer often works around the 8-10 range.
So focus on getting close to 8. Nine won't help that much and the leap to 16 is tough even for Bridgewater Associates ( http://www.bwater.com ) and David Swensen ( http://en.wikipedia.org/wiki/David_F._Swensen ) did well by adding just one (timberland) to the Yale endowment.