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What Is the Purpose of Diversification?

Before starting to trade, it is important to identify different ways to protect your investments and how to manage risk. One of the most important and common ways to do this is through diversification.Investors and traders alike constantly tout the benefits of diversifying your portfolio, but what does this really mean? 

What does Diversification within trading look like?

Diversification is a technique that reduces risk by allocating investments among a variety of financial instruments, industries, and other categorizations. The goal of diversification is to maximize profits while preventing overexposure to any one category. For example, diversifying   in terms of financial instruments means to invest in stocks, bonds, cash, futures, commodities etc. instead of just focusing on one.

Also, to prevent overexposure, traders must consider the qualitative relationships between different securities. For example, owning shares in a gold mining company and owning physical gold represents a diversification of asset class but does not diversify true exposure. This is because stock prices of gold mining companies are highly correlated to physical gold prices; an unfavorable move in the price of gold would produce severe losses for a trader whose positions are concentrated in these two assets. 

More uncorrelated the companies, industries, and asset classes cultivate better diversification because these investments will react differently to the same events. Lastly, something to consider when making a trading plan is location. Geographic diversification can be beneficial since a sudden downturn in the United States market could be balanced out if you have assets in other forex markets. An event that affects one country may not have any impact on another, so this is a great way to offset any losses. 

Why should we diversify?

We know that we diversify as part of risk management, but how does this really work? Again, diversification allows us to maximize profits as each industry or financial instrument we invest in reacts differently to the same event. Imagine investing all of your money into an airline company. Now, a pandemic strikes resulting in a major drop in this airline company’s stock price. With all of your money invested in this one company, the event has caused a major disruption in the value of your portfolio. However, now think about if you invested in the airline company, a technology mutual fund, bonds, and maybe some other forex investments. In general, if only a fraction of your invested money is for the airline, a sudden drop in the airline stock only affects a small portion of your overall portfolio. In other words, diversification allows you to mitigate risk by investing in a variety of assets that are preferably uncorrelated.

This concept is an extrapolation of the underlying assumption that no trader has perfect information. Accordingly, traders must design allocations with the expectation that some meaningful proportion of those allocations will produce losses. In the cases where losses are extreme (such as airline stocks after COVID-19), diversification enables traders to preserve capital and continue participating in financial markets. 

Are there any downsides to diversification?

Although diversification may seem like a free-lunch, the reality is that it will become increasingly difficult for traders to produce excess returns as they continue to add new holdings. That is, it is extremely difficult to successfully produce a market-beating return in a single component of the broader market, let alone across countless industries, asset classes, and instruments. If traders take too many positions, they will inevitably become overwhelmed with the task of managing those positions and will be forced to consolidate their holdings. An effective method to navigate balancing diversification with limitations on how many positions a trader can track is to trade a small number of securities which are either uncorrelated or negatively correlated. By doing so, traders can exploit short-term inefficiencies in each security while hedging against massive drawdowns caused by black-swan events. 

The graph above was included in Stephen Lee’s paper “The marginal benefit of diversification in commercial real estate portfolios”. His research showed that after 10-20 properties, further diversification had essentially no impact on risk levels. This asymptote-like curve is roughly present in every asset class. 

Key Takeaways

Diversification is one of the most common ways to maximize profits in your portfolio while preventing severe losses. Diversification must be paired with stop-losses and other risk management practices to ensure capital preservation. Additionally, the marginal benefit of additional diversification decreases as a portfolio becomes more diverse. New traders who do not feel comfortable managing the number of positions required for effective diversification can also hold a large portion of their portfolio in cash until they become more comfortable trading. 

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