Why 3 to 5 Strategies?

following my last post

1. Empirical Evidence: The Diminishing Returns of Diversification

One of the most well-known studies in finance on diversification was done by Evans & Archer (1968), which examined how adding more assets to a portfolio reduces risk. The findings showed:

📌 Key Insight:

“A well-diversified portfolio of as few as 3 to 5 uncorrelated assets captures most of the risk-reduction benefits of diversification.”
— Evans & Archer (1968), "Diversification and the Reduction of Dispersion: An Empirical Analysis"

This means that beyond 3 to 5 assets or strategies, the incremental reduction in risk becomes marginal. If the strategies are uncorrelated, most of the diversification benefits are already achieved with a small number of them.

📊 Diminishing Marginal Benefit of Diversification:

• 1 strategy → 100% of its risk.

• 2 strategies → Risk drops by ~30% (if uncorrelated).

• 3 strategies → Risk reduction approaches 50%.

• 5 strategies → 80-90% of the total possible risk reduction achieved.

• 10+ strategies → Only minor additional risk reduction but increased complexity.

This principle is directly applicable to multi-strategy trading portfolios.

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2. Studies from Hedge Fund & Institutional Investing

Hedge funds and institutional investors often operate multi-strategy portfolios, and research suggests that 3 to 5 is the optimal number of strategies for balancing risk and return.

📌 Quote from AQR Capital Management (Cliff Asness, 2013):

“A portfolio of at least 3 to 5 uncorrelated strategies improves the Sharpe ratio significantly, beyond which additional strategies only add complexity with diminishing returns.”
— AQR Research on Multi-Strategy Investing

Hedge Fund Data:

A study of hedge fund performance (Fung & Hsieh, 1997) analyzed multi-strategy hedge funds and found that:

• Funds using 3-5 strategies outperformed funds using 10+ strategies due to focused risk-taking.

• Portfolios with too many strategies exhibited lower returns due to over-diversification (“diworsification”).

• Uncorrelated strategies provided maximum risk-adjusted returns when balanced properly.

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3. Portfolio Optimization Theory: Mean-Variance & Risk Parity

Modern Portfolio Theory (MPT) suggests that a small set of uncorrelated assets creates an efficient frontier, maximizing returns for a given level of risk.

📌 Markowitz (1952) on Diversification:

"Beyond a handful of uncorrelated assets, diversification offers little additional risk reduction."
— Harry Markowitz, Nobel Prize Winner, Father of Modern Portfolio Theory

📌 Risk Parity Research (Bridgewater Associates, 2011):

• 3 to 5 strategies provide near-optimal risk balancing.

• Beyond that, adding more strategies has diminishing benefits and makes risk management harder.

Why Not Just 2 Strategies?

Two strategies might still be too risky because correlation can spike in crises. A third or fourth strategy provides a buffer against unexpected correlations during downturns.

📌 Ray Dalio (Bridgewater Associates) on Portfolio Resilience:

"A portfolio of at least 3 to 5 well-chosen uncorrelated return streams is robust against economic shocks."
— Principles for Navigating Big Debt Crises (2018)

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4. Real-World Multi-Strategy Fund Examples

Examples of Successful Funds Using 3-5 Core Strategies

Many top-performing hedge funds focus on 3-5 core strategies, rather than over-diversifying:

• Renaissance Technologies (Medallion Fund): Uses 4-5 primary strategies that dynamically adjust.

• AQR Capital Management: Uses 3-5 factor-based models to optimize risk-adjusted return.

• Bridgewater Associates (Pure Alpha Fund): Focuses on a small number of uncorrelated risk premiums.

These funds show that optimal strategy allocation is not about having more, but about having enough to balance risk while maximizing return.

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5. Practical Considerations: Keeping It Manageable

Beyond the theoretical and empirical studies, having too many strategies creates operational challenges:

📌 Why 3 to 5 Strategies is Practical:
✅ Each strategy gets a meaningful allocation (not diluted across too many trades).
✅ Simplifies risk monitoring (fewer moving parts).
✅ Avoids redundancy (too many strategies may end up behaving similarly).
✅ Maintains capital efficiency (ensuring capital is deployed where it’s most effective).

Over-Diversification Weakens Performance

📌 Quote from Warren Buffett:

"Diversification makes very little sense if you know what you’re doing."
— Berkshire Hathaway Annual Meeting (1996)

While he was talking about stock investing, the same principle applies to trading strategies. Beyond a certain point, adding more reduces the impact of winners and drags down overall returns.

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Final Answer: Why 3 to 5 Strategies?

✔ Empirical Studies: Show that 3 to 5 strategies capture most of the risk reduction benefits (Evans & Archer, 1968).
✔ Hedge Fund Research: Finds 3-5 strategies improve Sharpe ratio with diminishing returns beyond that (AQR, Bridgewater, Fung & Hsieh).
✔ Modern Portfolio Theory: Suggests a handful of uncorrelated assets maximize risk-adjusted returns (Markowitz, 1952).
✔ Real-World Success: Top hedge funds limit the number of core strategies to avoid unnecessary complexity.

Thus, 3 to 5 is the sweet spot for a multi-strategy trading portfolio—enough to be diversified, but focused enough to keep returns high and risk under control.