Introduction

In systematic trend following, diversification is more than a risk management tool; it’s the gateway to capturing high-impact returns from unexpected outliers. By spreading exposure across a wide range of markets—from commodities and equities to bonds and currencies—trend followers increase their chances of encountering rare, high-magnitude price events that drive substantial returns over time.

Each added market raises the chances of capturing an outlier, creating a portfolio that thrives on unique, uncorrelated price movements. This broad exposure doesn’t just dilute risk; it amplifies the portfolio’s potential by reducing reliance on any single market or sector, smoothing returns and adding resilience. When markets move independently, diversification provides a natural balance that helps to steady returns even as individual sectors fluctuate.

In this blog, we’ll explore how diversification serves as a powerful tool for Outlier Hunters (a sub group of the broader trend following community, also referred to as Classic Trend Followers), not only by managing risk but by unlocking the potential to capture elusive, high-impact trends. We’ll discuss why broad market exposure improves the odds of capturing outliers, enhances risk management, and ultimately strengthens a trend-following portfolio’s edge in an unpredictable market landscape. For Outlier Hunters, diversification is a proven strategy that keeps them ready for any trend, anywhere, at any time.

Why Diversification is Key in Trend Following

To maximize the likelihood of encountering these massive trends, Outlier Hunters turn “luck” into a structured strategy. By positioning broadly across many markets and with many systems, they ensure they’re in the right place, and with systematic processes in place, they’re ready to act at the right time. This approach captures those rare, high-impact price movements that lie at the extremes of the distribution curve, providing Outlier Hunters with a reliable framework for capturing substantial, often unexpected returns.

Outliers can emerge in any asset class, at any time, and often without warning, making broad exposure crucial. By diversifying widely across commodities, equities, bonds, and currencies, Outlier Hunters reduce dependence on any single market or sector. Each added market raises the probability of encountering an outlier and increases the potential for unique, uncorrelated price movements that amplify returns.

A common misconception is that diversifying across too many markets dilutes returns by weakening the impact of major winners. This “dilution myth” overlooks the defining nature of outliers—non-linear, high-magnitude events that far exceed typical market movements. By casting a wider net, diversification actually enhances long-term performance for the Outlier Hunter, as each new market opens the possibility of capturing an outlier that concentrated portfolios might miss.

Additionally, as is the case with other forms of trend following, broad diversification reduces a portfolio’s exposure to adverse moves, smoothing returns over time. By balancing positions across diverse assets, trend followers can absorb losses in one area while profiting in another, providing a natural hedge against sector-specific risks. Diversification becomes a proactive approach to managing risk, ensuring the portfolio is always ready to capture high-magnitude trends across different forces and market dynamics.

In essence, diversification for Outlier Hunters is more than just protection; it is a powerful strategy for optimizing the capture of outliers, reducing volatility, and achieving stable, resilient performance. Through a broad, systematic approach, Outlier Hunters reframe the unpredictability of outliers into a structured advantage, turning “luck” into an intentional, process-driven edge in the pursuit of market outliers.

Understanding Tail Events and Their Role in Performance

In trend following and in particular Outlier Hunting, performance is driven not by the average daily price movements but by the rare, extreme events—outliers—that occur infrequently but have significant impact. These tail events fall at the edges of the market’s return distribution and represent extraordinary price moves that trend followers aim to capture. Unlike conventional strategies that focus on capturing gains within the bulk of the distribution curve, Outlier Hunters intentionally target the extremes, recognizing that a single powerful trend can often outweigh the performance of hundreds of small trades. This focus on outliers is what differentiates Outlier Hunting from other forms of trend following and makes tail events so crucial to its success.

Tail events, often sparked by sudden shifts in supply-demand dynamics, geopolitical events, or macroeconomic surprises, create the high-magnitude trends that trend followers seek. While the day-to-day movements of markets may appear random or oscillatory, tail events drive sustained trends that can last weeks, months, or even years. When these trends take off, our trading strategies are built to stay in the trade and maximize returns, riding the price movement for as long as the trend remains intact. These tail events may only represent a small percentage of overall trades but contribute disproportionately to overall returns. By capturing these outsized moves, Outlier Hunters can generate performance that far exceeds the sum of smaller, more frequent trades.

In 2024, certain markets have exemplified the power of tail events in trend following, with Cocoa standing out as a prime example. Cocoa experienced a historic trend, with prices rising sharply over the year, driven by factors such as supply constraints and shifts in global demand. For trend followers, Cocoa’s surge offered an ideal opportunity to capture a high-magnitude move. The trend, fuelled by fundamental imbalances, provided substantial returns to those who had the exposure and strategy in place to ride it.

Other markets, including XAUAUD (Gold priced in Australian dollars), BTCUSD (Bitcoin), Orange Juice, and GBPJPY (British Pound/Japanese Yen currency pair), have also demonstrated outlier behavior in 2024. Each of these markets experienced significant trends that, while unique in their drivers, underscored the value of wide-reaching diversification in a trend-following portfolio. By having a presence across varied markets, trend followers were positioned to capture these tail events, reinforcing how diversification enhances the potential to capture outliers and drive overall performance.

If you want to view how an Outlier Hunter’s process captures these massive anomalies then refer to our previous blogpost where we provide a visual walkthrough for Cocoa, Bitcoin, Gold, Orange Juice and GBPJPY.

In Outlier Hunting, it’s the tail events like these that define the success of a strategy, making broad market exposure essential. Each tail event represents not only a unique opportunity but a reinforcement of the trend-following principle: by systematically positioning for the extremes, traders can consistently capture the exceptional returns that drive long-term performance.

Optimizing for Stability: Managing Portfolio Risk

Wide exposure helps capture more outliers and creates a natural buffer against specific risks, balancing gains and losses for smoother returns. By diversifying across numerous, uncorrelated markets, trend followers effectively reduce the impact of any one market’s volatility on the overall portfolio, which stabilizes performance over time.

A key concept in this strategy is managing volatility drag, which occurs when large adverse fluctuations in a portfolio’s value hinder compounding returns (Note: There is beneficial volatility and adverse volatility. All forms of volatility are not equal) . For instance, a sharp drawdown reduces the capital base, requiring higher gains to recoup losses. A well-diversified portfolio mitigates this effect by minimizing the impact of extreme price swings. Through uncorrelated positions, the likelihood of simultaneous losses across all markets is reduced, acting as a cushion against volatility drag and preserving capital for future growth.

Diversification across different asset classes—commodities, currencies, bonds, and equities—creates a hedge within the portfolio. When one market experiences losses, uncorrelated positions in other markets can offset those losses, providing a more consistent and reliable return stream. This broad market exposure thus acts as both a strategy for capturing a wide array of trends and a tool for managing risk, resulting in lower drawdowns and a foundation for compounding returns over the long term.

By optimizing stability through diversification, trend followers enhance portfolio resilience, reduce the disruptive effects of volatility, and support steady performance, maximizing the opportunity to capture outliers across varied market conditions.

System Diversification: Layering Strategies for Resilience

System diversification involves employing multiple, distinct trend-following strategies within a portfolio to capture trends across various timeframes and market conditions. The purpose of system diversification is to create an additional layer of resilience, ensuring that the portfolio isn’t overly reliant on a single trading strategy. Different trend-following systems may respond uniquely to price movements, generating signals to enter or exit trades at different points within a trend. By layering these systems, trend followers can capture a wider array of trends, reduce sensitivity to specific market phases, and smooth returns by balancing the strengths and weaknesses of individual systems.

One key benefit of system diversification is its ability to reduce correlation within the portfolio. When the same strategy is applied uniformly across markets, trades are likely to produce highly correlated results, especially when markets share similar characteristics or are affected by the same events. However, by deploying multiple trend-following systems with varying parameters—such as timeframes or entry/exit rules—trend followers can generate a diverse set of return streams. Some systems may perform better in long-term trends, while others might capture shorter, sharper moves. The result is a portfolio with less internal correlation, where gains in one system can offset temporary underperformance in another, leading to more consistent overall performance.

For trend followers, balancing both market and system diversification is essential to maximizing returns while managing risk. Market diversification ensures broad exposure across uncorrelated assets, increasing the likelihood of capturing outliers and reducing exposure to any single market’s risks. System diversification complements this by reducing reliance on any single strategy, providing a hedge against the limitations of individual systems. Together, they create a robust portfolio structure that is well-equipped to capture trends across diverse assets and under varied market conditions.

An optimal approach combines a wide array of markets with multiple systems that exploit different aspects of price behavior. This synergy between market and system diversification enhances portfolio resilience, lowers drawdowns, and supports a smoother performance profile. By carefully balancing these two layers of diversification, trend followers position themselves to maximize their edge in an uncertain market environment, ready to capture outliers wherever they may arise.

Empirical Evidence: How Diversification Enhances CAGR and Stability

Our research shows that portfolios with broader diversification achieve higher returns and smoother performance over time. As the number of uncorrelated return streams included in a portfolio increases, both the portfolio’s Compound Annual Growth Rate (CAGR) and stability improve significantly. Diversification enables these portfolios to capture more outliers while mitigating the risk posed by individual market fluctuations.

For instance, in a backtest comparing portfolios with varying levels of diversification—from a core group of 100 uncorrelated return streams to a maximum of 500—results consistently showed that portfolios with broader diversification experienced higher and more stable growth. As seen in Chart 1, which compares diversified portfolios, portfolios with more return streams achieved a consistently higher CAGR while showing less variation in returns, or “dispersion,” which refers to the range of performance outcomes. This reduction in dispersion means that returns are more predictable and drawdowns are less severe, thanks to the diversification’s smoothing effect.

Chart 1 illustrates how, as the number of uncorrelated return streams grows, returns cluster more closely around an optimal balance between growth and risk. This concentrated effect is a key benefit of diversification: by spreading exposure across many unique markets, portfolios experience lower volatility drag, ensuring that random fluctuations in any one market have minimal impact on the portfolio as a whole.

The research underscores that increasing diversification not only enhances returns but also improves the consistency of those returns, providing a critical edge for Outlier Hunters aiming to capture unpredictable outliers while minimizing risk.

Chart 1: Scatterplots under Different levels of Diversification: Left: Smaller Trend Following Portfolios offer far higher dispersion in performance. You need to be lucky with a smaller portfolio to become exposed to Outliers. As diversification increases, performance dispersion signficantly reduces. Right: Applying an equivalent Drawdown to this selection of portfolios demonstrates that CAGR increases and stabilises with far lower dispersion in results. 

Dynamic Position Sizing and Risk Adjustments: A Comparison

Dynamic position sizing involves adjusting trade sizes based on trend strength/quality or certain risk metrics, such as volatility or capital levels, as trades evolve. The primary advantage of this approach is its adaptability to changing market conditions. By scaling positions up or down based on volatility or other factors, traders better manage risk exposure during periods of market turbulence or opportunity. However, dynamic position sizing also has notable drawbacks. Constant adjustments can lead to over-trading, increasing transaction costs, and exposing the trader to “whipsaw” effects where positions are adjusted too frequently, eroding overall returns. Furthermore while dynamic sizing can add flexibility, it may also detract from the “let your profits run” philosophy that classic trend followers (colloquially known as Outlier Hunters) rely on to capture large outliers.

Classic trend following typically takes a straightforward approach: a position is entered based on a trend signal, with the size set at the outset according to a pre-defined risk level, often using metrics like the Average True Range (ATR) to size the initial position. Once a position is established, it is rarely adjusted. This approach minimizes transaction costs, allowing profits to compound on a single position without interference. Volatility-adjusted approaches, on the other hand, continuously scale positions based on ongoing market conditions. In these strategies, positions may be reduced as volatility rises to prevent excessive drawdowns or increased when volatility decreases. While volatility-adjusted approaches can help smooth returns, they can also lead to missed gains in strong trends, where adjustments might cause a trader to exit early or hold smaller positions than optimal. Furthermore, when it comes to tail events, non-predictable chaotic price moves as opposed to predictable well mannered trends tends to rule the day, and attempts to statistically quantify these anomalies  to apply Gaussian rules may come at a cost. Under chaos, ‘loose pants’ allowing for maximum price freedom allows for unpredictable trajectories to unfold. In the ‘tails’, predictive assumptions are to be avoided.

Position adjustments can add value in certain market environments and assist in reducing levels of required diversification to mitigate drawdowns, particularly in highly volatile or choppy markets where drawdowns are more pronounced. By adjusting position sizes in response to increased volatility, traders can limit potential losses. For example, reducing position size in a high-volatility environment can prevent substantial drawdowns, helping preserve capital for future opportunities. Conversely, in strong, trending markets where volatility remains steady or decreases gradually, position adjustments may detract from overall returns. Cutting back on positions during a sustained trend can reduce the portfolio’s exposure to outliers, missing the full potential of a profitable trend. In a nutshell Outier Hunting demands diversification to smooth the ride whereas dynamic position sizing methods smooths the ride without the same need for diversification to play a hand, however we believe this comes at a cost, where more concentrated portfolios can miss some massive Outliers that gives the Classic Trend Followers their porffolio ‘lifting power’.

The insights from the discussed charts further emphasize this point. Classic trend-following portfolios that maintain fixed positions show increased stability and capital growth over time, with fewer adjustments reducing transaction costs and capturing maximum gains on outliers. Thus, while dynamic position sizing can be valuable for risk management, its role should be carefully considered based on the market environment. Classic trend-following strategies generally benefit from a “set and let run” approach in strongly trending markets, as this ensures maximum exposure to outliers—fundamental drivers of trend-following success.

Preserving Capital: Flexibility for Outliers

A key strategy for Outlier Hunters is maintaining sufficient cash reserves to respond to new outlier opportunities as they arise. By preserving capital and avoiding full allocation, Outlier Hunters can enter new trades that exhibit promising trend signals, even in environments of high market volatility. This flexibility allows for broader participation across markets without being constrained by over-commitment to existing trades. Managing cash reserves also acts as a buffer against drawdowns, ensuring that capital is available for the next significant trend without forcing the trader to exit other profitable positions prematurely.

Trend-following portfolios benefit from broad market exposure, but not all markets will signal trends at the same time. Diversified portfolios that maintain flexibility in allocation can take advantage of opportunities across diverse asset classes—commodities, equities, currencies, and bonds—allowing the portfolio to capitalize on idiosyncratic price movements without locking capital into any single market. This adaptability supports the core objective of Outlier Hunting: maximizing exposure to outliers while minimizing capital entanglement in non-trending or correlated positions. A flexible allocation approach enables portfolios to remain dynamic, participating selectively as new trends develop across an ever-expanding universe.

Preserving capital also involves the delicate task of balancing portfolio exposure, ensuring that no single market or position consumes disproportionate resources. Allocating capital too heavily to any single position or sector can limit a portfolio’s capacity to capture new outliers and increase vulnerability to unexpected drawdowns. By balancing exposure with a focus on capital preservation, trend followers can avoid over-allocation and maintain a broad, flexible stance.

This measured approach ensures that capital is ready to be deployed when outlier opportunities present themselves. Portfolios that carefully manage exposure levels—avoiding excessive commitment to any one trade or market—are well-positioned to capture outlier events across diverse markets. Ultimately, this strategic flexibility is central to a trend follower’s ability to benefit from high-impact trends without compromising resilience, preserving the capacity to engage with the next big opportunity.

The Case for Maximum Diversification in Trend Following

Broad diversification is more than a strategy; it’s a foundation for capturing outliers, reducing volatility, and building a resilient trend-following portfolio. By expanding exposure across multiple uncorrelated markets and employing diverse systems, Outlier Hunters increase their chances of encountering high-impact trends while smoothing overall performance.

Through this wide-reaching approach, trend followers avoid dependence on any single market or strategy, creating a portfolio that thrives on diversity and unpredictability. By embracing broad diversification, they unlock resilience and the capacity to benefit from unexpected moves, positioning themselves for growth and stability in an uncertain landscape.