Portfolio-of-Portfolio Testing
Diversification
Every trade has three basic risks – asset-specific risk, sector risk, and market risk. But every trader has yet another type of risk – strategy risk. No strategy has perfectly repeatable, consistent returns. Trading strategies like the market itself have their up’s and down’s. They have flat periods where they go dormant and periods when they are hugely profitable. All to often, traders give up on a trading strategy or system that is underperforming and quit trading it just before it explodes again. And, even worse, trading systems do quit working – usually when too much money starts piling in. So how does a systems trader protect him or herself from this inherent risk? The answer is through diversification – trade multiple strategies.
Strategy Testing – Three Cases:
There are three broad types of strategies:
- Individual asset test – this is the easiest type of backtest
- Portfolio test – single strategy applied to a basket of stocks or commodities
- Portfolio-of-Portfolio (PoP) test – multiple strategies are applied to baskets
The Portfolio Test allows you to diversify across different assets with a single strategy. The PoP test allows you to diversify with different strategies. The Portfolio-of-Portfolio capability of our software platform enables simultaneous testing of multiple strategies such that the overall diversification impact can be fully understood.
Portfolio-of-Portfolio Testing
Backtesting multiple portfolio strategies simultaneously is a very complex endeavor. Different entries and exits may be used in different strategies, different liquidity constraints, different number of positions within the portfolios, and the equity allocated may differ between strategies. Additionally, you may want to limit the number of different strategies that can take a trade on an individual asset at a given time. This could significantly alter the performance and risk profiles of individual strategies as well as the combined portfolio of multiple strategies. The unique Portfolio-of-Portfolio capability of our software platform takes all of these issues into account. Market Testing Wizards can take the guess-work out of combining trading strategies.
