Diversification, as every novice to financial markets is told, is A Good Thing. The opposite strategy, putting all your eggs in one basket, is not. To diversify your assets is to guard against events that may wipe out one particular asset class, because your other assets will not, in the jargon, be to that class.
Think of diversification as a series of firewalls within your holdings. A conflagration in one section is prevented from spreading to the others.
It all sounds reasonable enough, but it is fair to say there are a fair few diversification sceptics about. Their objection usually boils down to the assertion that low risk equals low returns – if it were otherwise, why isn’t everybody diversifying like crazy and getting rich in the process?
Worth the effort?
Let’s look at two questions in order. First, has diversification in general been oversold as a concept? Second, even if the answer is no, is diversification mainly of relevance to investors, rather than traders?
Mathematically, diversification certainly works, regardless of whether you are holding a security for ten minutes or ten years. The probability of losing money tends to reduce the more assets are held.
True, in our example the outcome for gold and the dollar would be less clear cut than an election result. It is possible that you could come out marginally ahead. But it is possible also that you could come out marginally behind.
They key word here is “marginal”. Is it really worth the effort?
What is more, we have yet to discuss an aspect of diversification of which our mathematical model takes no account – fees or charges. By definition, returns are eroded by such charges, especially when they are structured around the number of assets held rather than as a flat percentage of the value of all holdings.
So, in the real world outside the maths classroom, any diversification strategy has to take full account of these charges and to seek a financial services provider whose fee structure best accords with the diversification strategy in question.
In light of this, should the answer to our second question be yes, diversification may well work for investors, especially those taking a long-term view of their investments. For example, over time, a stock-market investor ought to see the “winners”, in terms of company shares, even if outnumbered by the losers, provide positive returns, simply because the more diversified a portfolio, the better the chance that it contains some spectacular success stories that will more than compensate for the losses.
Relevant, or not?
But these success stories will take time to emerge.
Surely diversification is of limited relevance to a trader?
In fact, the very same principle applies, albeit in a different form. Suppose our investor had decided that, rather than assemble a diversified portfolio, they would try to pick those spectacular winners from the outset?
Of course, they may have been successful, in which case their overall return would have been much greater because there would have been no deductions for the cost of the failed investments. But how likely, in reality, would such success have been?
You could be proved right. If the personal trading record that all traders are advised to keep shows your previous trades paid off, let’s say, 55% of the time, then, in simple terms, your big and costly dollar/euro trade has a 55% chance of coming good.
That still leaves a 45% chance of failure, and this time the stakes are much higher. Bear in mind also that 55% is an average that emerged over a long series of previous trades. There is no guarantee that it will be repeated on this single occasion.
In short, diversification is far from irrelevant to traders. But there is much more to a diversified strategy than simply collecting a batch of apparently-different pairs and then trading them.
Such a strategy would be diversified only in the superficial sense that the assets in question appeared to have little in common. The vital word here is “appeared”.
Watch fees and charges
The key to successful diversification is to pursue, in the jargon, minimum correlation among the different assets. This means that it is not enough for securities just to look different – traders need to search for hidden linkages that expose apparently-diversified assets to similar risks.
For example, you could be trading a view on Brent crude at the same time as trading the . The link here is that China’s economic health is an important indicator of oil demand, thus similar risks face both assets.
In conclusion, diversification as a concept is highly relevant to traders, as well as investors. They ought to have a full understanding of the relevant fees and charges in putting together their diversification strategies. They should avoid largely-pointless diversifications, as seen in our example of betting on both sides in an election.
And they should always seek to uncover the hidden linkages that undermine diversification.
Watch our video to learn more about diversification.