What happens when your porfolio correlates to 1?
Posted: Thu Oct 06, 2011 1:17 pm
I have not found it beneficial to limit total risk in my systems. I think this is primarily due to having uncorrelated instruments in the portfolio. Adding more and more uncorrelated instruments while increasing total risk, should decrease "effective" risk.
However, what happens if the instruments become highly correlated? (nothing says they cant) We could have a big problem. One idea I have been tinkering with is reducing position size across the portfolio if volatility of the equity curve exceeds some predetermined figure.
This could be measured as % change over sometime frame, average daily change, standard deviation of returns, etc. I like to normalize this figure by adjusting it by the % or $ at risk over the same time period.
One concern is the robustness of this rule. If we want to reduce position size if vol > x% and this rule only is triggered 10 or so times over the life of a test, is it something we should hang our hats on? Although perhaps we are erring on the side of caution if we do...
Has anyone else pondered this issue?
However, what happens if the instruments become highly correlated? (nothing says they cant) We could have a big problem. One idea I have been tinkering with is reducing position size across the portfolio if volatility of the equity curve exceeds some predetermined figure.
This could be measured as % change over sometime frame, average daily change, standard deviation of returns, etc. I like to normalize this figure by adjusting it by the % or $ at risk over the same time period.
One concern is the robustness of this rule. If we want to reduce position size if vol > x% and this rule only is triggered 10 or so times over the life of a test, is it something we should hang our hats on? Although perhaps we are erring on the side of caution if we do...
Has anyone else pondered this issue?