Most people considered Trade diversification a great way to manage risk.This is a good theory; however there are a few faults.
Most people considered Trade diversification a great way to manage risk. If you split your portfolio into many different stocks then even if some go down others will go up. That way your wins offset your losses. This is a good theory; however there are a few faults.
The first fault of diversification is that it works by finding a few good companies and hoping the wins on one will outweigh the losses on another. This is not always true, especially if you consider that stocks go down faster then they go up. If you bought 2 stocks each at $50 that would give you a little bit of diversification.
What if 1 of those stocks went to up $60 and the other went down to $30? You would have made $10 on 1 but lost $20 on the other. That is not a money making system.
When you are diversified you don’t care how much money you lose. You hope that after all is done you make money. When in reality you should care what you will risk.
Risk management always beat diversification. What if we used risk management on the 2 stocks above. Say we buy one of these stocks at $50. We decide that we are only willing to risk $2 on this trade. The stock starts to fall, and we get out at $48. We lost our $2.
Then we get into another $50 stock again decide that we are willing to risk only $2. This time it goes up to $60. We made $10, which more than makes up for our $2 loss.
Now I know there are hard core diversifications out their saying that you can’t diversify with just 2 stocks. Some people say you need at least 20 or 30 stocks. While this sounds good because all and all stocks go up it is probably not the most effective way to do things.
Think about it, when you buy 1 quality stock you have a good chance of beating the market average. When you buy 10 stocks you have a significantly lower chance of beating the market average. The more stocks you buy the harder it will be to beat the market.
So, essentially when you diversify too widely you are saying that you cannot beat the market. And the market average may only be 5-10%. That is nothing compared to what professionals pull out.
It is much better to have only 1 or 2 stocks at a given time and limit your risk on those stocks. Warren Buffet once said “I prefer to keep all my eggs in one basket and watch that basket closely.”
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