Wednesday, July 6, 2011

Diversification Continued....

Below is a simple example of how you might start to think about diversification. Although it is not all encompassing, it does a good job at illustrating all the components that make up an investment decision. It shows that although you may be looking at two different stocks or bonds; they may still share many other qualities, which can hurt your goals of diversification.

Here are some examples of diversification strategies as well:

These figures barely/hardly scratch the surface of how I will attempt to quantify diversification into "levels." However, the lingo of "Conservative, Aggressive, etc.." will be relatively similar. It no longer suffices to include only the categories of "Large Cap, International, Small Cap, Bonds, and Cash" due to the prevalence of new financial instruments such as ETF's and derivatives. So, for the purpose of this post, we will solely define the scope of our application.

We will include the following:
  1. Stocks
  2. Options
  3. ETF's
  4. Bonds
  5. Mutual Funds
  6. Cash 
Furthermore, the first five items in the list can be broken down even further.

For Stocks:
  1. Market Capitalization
  2. Industry
  3. Geography
  4. Volatility
  5. Dividend or No Dividend
For Options:
  1. IN/OUT of the Money
  2. All Aspects of Stock Above
  3. Length to Expiration
For ETF's:
  1. Allocation of Assets
  2. All Aspects of Stocks Above
  1. Credit Rating
  2. Length to Maturity
  3. Type of Bond
Mutual Fund:
  1. Manager
  2. All Aspects of Stock
I will build an algorithm that is capable of taking into account all the factors present for each of the different asset classes outlined above. It will then output a rating of diversification. I will start with a python application, and then progress to an iPhone application.

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