Sometimes, you may come across a system with a huge drawdown that you’re not willing to take, but the potential returns are just too mouthwatering to pass over.

For example, a system (let’s call it Trading System A) that is profitable in the long run, but suffers a drawdown of between 30% to 40% of your trading equity.

Example: Trading System A Statistics
Risk (potential maximum drawdown): 40%
Return (Potential): 150% p.a.

What some traders might do is to chuck the system aside, even though it’s profitable. However, if it’s a system that you want to trade because of the tremendous profit potential, what do you do?

Portfolio Management and System Diversification

For example, let’s start out with a $100,000 portfolio. I’m using $100,000 for the ease of calculation, and the fact that you do need a certain size in order to trade several systems at one time. If your trading capital is too small, the best thing you can do is to focus on trading one system and trading it really well. When your trading capital has grown enough, you can then consider trading more than one system to “smooth out” the drawdowns in your portfolio.

If you have $100,000 in trading (risk) capital, you could consider trading more than one system at a time. This is more for the potential of reducing your portfolio drawdown versus the risk of trading only one system.

So, getting back to the topic of this post, Trading System A has a potential drawdown of 40%. If you were to trade the entire $100,000 on Trading System A, you could suffer a potential drawdown of up to $40,000!

Portfolio Diversification through Capital Allocation

Diversification is used to Reduce Risk FIRST!

Diversification as an investment strategy is something that has been talked about and used in the investment world for a very long time. The main reason for using diversification is to reduce risk. The secondary reason is to enhance the returns on your investments if it’s possible.

The simplest method to reduce your portfolio drawdown (or portfolio risk) is to allocate out a smaller percentage of your trading capital for Trading System A. Instead of investing the entire $100,000, you can just allocate $10,000 (or 10%) of your trading capital. This way, your portfolio drawdown immediately drops from 40% ($40,000 of $100,000) to just 4% ($4,000 of $100,000).

Trading System A with 100% Allocation
Capital Allocation: $100,000
Drawdown (%): 40%
Drawdown ($): $40,000
Portfolio Drawdown: 40%

Trading System A with 10% Allocation
Capital Allocation: $10,000
Drawdown (%): 40%
Drawdown ($): $4,000
Portfolio Drawdown: 4%

As you can see, with a simple tweak to your trading strategy, you have reduced your portfolio risk from 40% to just 4%, while still maintaining the potential of garnering the returns of Trading System A.

Of course, the overall returns on your portfolio would not be as great when only using 10%, but when you add a profitable trading system to your arsenal while still maintaining portfolio volatility that you can stomach, it’s not so bad, right?

Besides, Higher Returns usually equals Higher Risks.

Summary

Now, the question is what are some of the reasons you would want to use this strategy?

1. When you have a system that is just bursting with potential returns, but that come with a high risk.
2. Your trading systems are automated and all you need to focus on are the money management and capital allocation aspects of your trading.
3. You just want to diversify your trading strategies to cover different market behavior, different markets, etc to reduce over-reliance on any one particular strategy.

The key thing is that diversification of your trading capital is designed to reduce the risk to your investments, while maintaining with low variations to your overall portfolio return.