Diversification for Stock Market Traders is Highly Overrated

Diversification for Stock Market Traders is Highly Overrated

Diversification across different financial assets seems to be the rage today but is it really that important?  Most gurus preach that you should diversify your capital across different asset bases such as commodities, property, stocks, CFDs, forex, hedge funds…etc and I have no doubt whatsoever that this is a sensible route to take but I do think that as far as trading is concerned diversification is not always the answer.

 Diversification is Highly Overrated

Diversification is highly over rated, and doesn’t necessarily pay out for traders – in fact rarely if ever.  Not if you want to make good money anyway.  The main reason for this is that there is an inverse relationship between asset classes and securities.  If your stock portfolio is truly diversified then, I can guaranteed you that whatever returns you make on one asset will be contra by losses on another, and whatever losses you suffer in one asset won’t wipe you out because of gains in other assets.

So in the long term, all things being equal your stock portfolio won’t perform great, but neither will it do badly, it is simply very well hedged…in fact too well hedged for a stock market trader.  In other words exposed to very little risk.

The sad reality is that there can be no profit without an element of risk.  The greater risk you take, the bigger the returns you stand to make, but also the higher the losses you will incur if your risk is not managed accordingly.  However, even so the presence of risk is a prerequisite.  In fact, our whole existence is based on risk.

Diversification does not seek to manage risk, but to eliminate it.

Diversification does not seek to manage risk, but to eliminate it.  It is true that a well-diversified stock portfolio of different shares and markets lowers the volatility and thus reduces the overall risk exposure but this has to be done sensibly.  Managing risk is a good strategy.  Most day traders and investors fail to manage risk at all and this is where so many get it wrong.  If you are looking to invest in the stock market I’d suggest you to ask yourself what kind of investor you are…  In a nutshell do you have an understanding of technical analysis and prefer technicals or are you fundamentally minded?   You shouldn’t mix the two.  And whatever risk you undertake must be in line with your trading or investing strategy.

Developing a spread betting trading strategy on your own is not easy, it takes knowledge, experience and perseverance. You can do it, but you must do your homework first – and lots of it, if you are up for it. As a matter of fact you need to be equipped with information even if you invest in a mutual fund.

 

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