The Upside / Downside of Diversification

Over on The Motley Fool (for whom I used to write), Malcolm Wheatley asks How much diversification is enough?

First of all, I think there are two reasons to diversify:

1. On the downside we need to diversify to spread our risk, because any stock can suffer a sudden collapse and take much of our portfolio value with it. If we’re going to take Warren Buffett’s alternative advice to “put all our eggs into one basket and watch it carefully”, then the only guaranteed way of watching it carefully is with a guaranteed stop order. Spread betting accounts from Capital Spreads, InterTrader, IG Index, SpreadEx and Spread Co provide those, but most stockbroker accounts do not.
2. On the upside of diversification, we need to have a finger in every pie because we have no way of knowing which one will rise first and fastest.

My suggestion is that if you have sufficient investment funds to spread around efficiently in your stockbroker account, or if you’re operating in a spread betting account — so that even small stakes are “efficient”, not degraded by dealing fees — then you might as well put a little money on every one of the horses in the FTSE 100 race. You are sure to have backed the winner, but of course you won’t actually make any money if you simply back every horse.

But this is a horse race with a difference, because you are allowed to change your bets as the race progresses. As some of the horses fall back and their “odds” become more attractive (i.e. you’ll get a bigger payout if they win) you might “average down” on them by betting a little bit more… but be careful with this tactic. More likely, you will take back your stakes from the stragglers — yes, you’re allowed to do that — and use the money to increase your stakes in the pack leaders. By the time you reach the finish line, you would ideally have all your bets concentrated in the first, second, and third placed horses… and, of course, you’ll be watching them carefully with whatever is the horse racing equivalent of a stop order (ideally guaranteed)!

Don’t take this too literally. The point I’m making is that diversification need not be static. It could make sense to have maximum diversification at the start of the race and maximum concentration at the end of the race, which is pretty much what my Position Trading approach is all about.

Sorry for the mixed metaphors of eggs in baskets, rising pies and racing horses. I’m sure you get the idea.

Disclaimer: this posting is for general education only; it is not trading advice.