The Importance Of Diversification (Part 1)

Diversification. It is that one word which invokes fervent debate amongst traders and investors, and is a prime thesis subject in academia. It is also something we haven't yet talked about and will hence do so in this tersely ornamented note.

Nature itself is infinitely diverse - a trait that is often sidelined as a key ingredient to Planet Earth's lasting legacy. The millions, if not billions of species that inhabit Earth has given nature its timeless splendor, and life its immense resilience. Standing the test of time, life has continued despite cryogenic ice ages and cataclysmic super-massive volcanic eruptions.

What is it that has given life the triumphant victory over death? Diversity. The very thing that Homo Sapiens have evolved to embrace through the sands of time. It is congenital and appealing to us. Vibrant pictures strike our retinas harder than those with pale color palates. Dynamic songs resonate so much better in our ears than monotonic trances. Yet we sometimes loath it, and therein lies the great paradox. But more on this later.

A lifestyle without variety is commonly thought to be boring, one not much better than being deathly acquainted to a rodent running in an endless loop. The maxim that "history never repeats itself but it often rhymes" is perhaps the zeitgeist of the modern conundrum. Is change a better bad or a worse good? 

Diversification In Trading & Portfolio Management

How does all that verbiage actually apply to the business of trading and portfolio management then? Do traders actually need diversity in their books, and do they indeed diversify? We have noticed that there lies a rifting paradox between what general life entails, and what people actually do when they speculate in the financial and capital markets.

Over the past few weeks, several traders have written in to us on how in a spot they felt in the current market climate. And we agree that it's not nice weather outside; week after week of bidirectional volatility, volatility that just isn't well reflected in popular measures such as the VIX, to take the stock market for instance. As though that was perplexing enough, everything seems to be indicating a different point everywhere we look. So what are we supposed to trust? 

The traders whom we spoke to are in a classic catch 22 situation. They have a choice of either being minimally exposed to the markets they usually trade (float in cash), or continue to meander through what is nearly almost unknown path punctuated with snare traps at every other turn.

The downside to the former is that when things start to clear (which may be from tomorrow to the next year), most markets would have already move substantially while we would still be sitting on a pile of cash. The upside of course is there is almost no risk of loss when exposures are trimmed to the minimal.

If a trader goes with the latter, he risks having his books ripped apart by the bidirectional volatility before the market eventually starts to clear up (which again may be at anytime). He would however stand to gain when the market turns on a dime, provided he was exposed in the correct direction.

When we talk about diversification, most traders and investors tackle at the matter by "not putting all eggs in one basket". In a typical equity portfolio, diversification can be achieved through a multitude of methods. We'll get back to this later on. 

Being Part Of Any Sustainable Business

The point we really wish to drive across is that diversification is important in irregardless of the business we are involved in. Most successful businessmen will tell you that in the long run, diversity is critical to sustainability. We don’t like to view the subject as an ideology but as a fundamental framework underpinning any business model.

There are the known unknowns, and there are the unknown unknowns. We're not messing around with words here. Diversification is a method used to mitigate risks that we can reasonably foresee. If we equate risks to the known unknowns, and understand that it is beyond our full control to manage these risks, then diversification makes all the sense in the world.

Adding in another factor called time greatly alters the way in which success is perceived. We like to think of time as a natural moderator. A tech startup may fare most excellently in its infancy even where most of its operations are essentially cost centers. The gradual transition from a startup to an actual profit-making establishment serves as the first real litmus lest that the business will face; and one that sees a low passing rate.

A quick look at the world's most valuable company (by market capitalization) shows that as precisely as Apple has positioned itself to be in its respective niche markets, it also operates in a very well diversified manner. The recent launch of the Apple Watch exemplifies this critical acumen.

If you're an entrepreneur looking to grow your business into something significant in the grander scheme of things, it would be great folly to eschew the fundamental importance of being properly diversified. This is why wealth generation strategies that promise multiple income sources that are so called "crisis-proof" sell like hotcakes with correct marketing.

Diversification Vs. Performance

Swinging back to trading and portfolio management, many traders are under the false assumption that being well diversified means settling for a lower performance. This misguided belief is often the reason why retail traders start trading on the entirely wrong foot. We shall explain. 

How we measure performance affects our mindset and ultimately molds the motivations that drive us. A wrong mindset will lead to eventual disaster.

To most retail traders, performance simply refers to returns. The way we measure and define performance affects our mindset we bear when we manage our own trading books or portfolios. Professional traders and portfolio managers know fully well that gross returns are only the tip of the iceberg.

Focusing solely on returns as a measure of performance not only puts traders in a potentially self-destructive path, but also motivates them to take on risk with wanton abandon all in hopes of inching out that marginal basis point of return.

It gets more ludicrous once traders are past that fleeting moment where a few largely profitable trades gives them that sugar high we all have experienced somewhere during our trading careers. Professional traders are never motivated by gross returns alone. Never.

Continued in Part 2...