Wednesday, May 27, 2009

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The Myth of Diversification in Trading Stocks

For a long time a theory has been taught for reducing the risk in investing or trading stocks. But this theory is taught only in one dimension when it could be applied in several dimensions. Everyone takes diversification in its literal sense and does not go beyond its obvious meaning. Come with me on my journey to explore diversification in its true dimensions, meaning and implication.

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The Diversification Theory in its Popular Sense

Diversification of your portfolio certainly reduces the risk. But let me tell you it also reduces the profit potential of your portfolio. You are into the stock market to make money at a faster potential than any other way. When you reduce this potential for the fear of risk then what is the point of taking risk at all. Remember when there is no risk there is no great reward.

This is where many traders fail to understand the implication of diversified portfolio. They only learn about reducing the risk but not about the reduced profit potential. They do not even take a step to think that the risk does not always mean you will lose.

When you bet on a risky stock two things can happen. You will either lose some money or gain some money. Depending on that risk or reward is decided. Stock traders, who diversify their portfolio, look at the risk aspect only and they are certain of making a loss only. What if you gained instead of a loss. That will even work like a cushion for the next bet.

This is Diversification for the First, Last and Single Bets

Raise your understanding beyond single bets. You are in the market to trade again and again, bet after bet till you reach your financial goals. It is not about one run. It is only through consistent trades that you will reach your ultimate goals. You cannot think of making your first bet the best bet and go away after that. That just is not going to happen atleast in the stock market for its variegated trends occurring at different periods of time.

Certainty of Risk with Diversification

One thing these traders miss to understand is the importance of risk certainty. It actually boils down to probability and I found stock market to be a wonderful place to apply all probability theories. When you bet on a single stock at any time your probability of making a loss is not certainly ‘1’ but when the loss is made it is a certain amount.

When you diversify to bet on multiple stocks, the probability of all stocks going broke at the same time is certainly reduced but the probability of atleast one bet going broke is greatly increased! How does this sound?

Did you notice that it is almost always common to see that some of your stocks do best and go green while some do badly and go red? Well, it happened to me all of the time I had diversified. Sometimes I had to close those failed bets at a loss that is half or even 90% of the bet amount. If I had bet on a single stock I would never let more than a 10% loss for short term trades.

By diversifying it is easy to lose this percentage picture at the stock level. When you almost certainly lose such a big amount on the part of your total amount, how is it safer than my type of bet where I may or may not lose 10% on total amount on a single bet?

Probability Plays Well with Diversification

This certainty of the loss increases with diversification because you are increasing the number of samples for a random event. Of course the certainty of a bet giving profit also increases but then again it is a lot less on the whole capital that is diversified on several stocks. Think of it this way. The statistics are calculated based on set of data which is extracted from certain number of samples. What every statistician knows to improve the accuracy of this data is to increase the number of samples. At some point the saturation limit is reached and the percentage of failed samples beyond this is always fixed.

If you take too less samples you will not get the right number of samples that can fail. This is because this sample number is close to 1. That makes it uncertain and random. The randomness is high with one sample. There is no randomness with large number or enough number of samples. That is when we calculate statistics and probability of certain results.

Not only is the loss a certain thing now but due to a lack of education on how to handle these losing bets, it manifests into reality. This violates the original intent of diversification in the first place. If you couldn’t plan to bet with a fixed loss limit but on a single stock, the diversification too will give a loss as much or more than the initial loss limit but with certainty. In other words you try to remove the random nature of the market to be safe. Think of a bad day like in October 2008, all bets going wrong at the same time with randomness.

But the market is no good without randomness. Unless your period of time is concentrated inside a bull market only, you cannot expect to gain anything, without randomness, better than fixed income investments. When you can alter your time period of trading, it means that there is another dimension to this randomness and diversification as well.

The Time Dimension of Diversification

It is the time dimension that also holds randomness for the stock market. That is, your bet is random not only because of the stock selected but also because of the time when the stock is selected.

Is it not very specific now as to where the uncertainty is coming from? By breaking the random nature of a bet on a stock into the selection of stock and timing, it becomes much easier to understand many implications that very few traders know about the stock market.

At any time your bet can go wrong because of the choice of the stock. If you don’t believe this then check the market statistics which list losers and gainers separately for the day, week or a particular time period. At any time there will be some stocks making a loss and some making a profit.

There will also be stocks that make profit in one period and make losses in another period of time and vice versa. This results in a bet going wrong due to the choice of timing. Note that nobody forces you to trade now. You have the choice to decide the entry time into a stock and also exit.

In other words stock trading is like a stochastic process. The random variable x is also random in time.

Diversifying in Time with the Same Stock

Thus there is another way to look at diversification, instead of in the stocks it is in the time. Whey you look at your bets, look at the time you bet. Think of the multiple bets you make one after another. Now the sample number is increased. That means the random nature gets reduced and also the risk. As per probability if you were to gain a certain number of trades and lose certain number of trades, then you know the risk, right?

This is not the risk but the loss you are certainly going to make after a certain number of bets. But this gets compensated with bets going right. So you can check your odds by changing the order in which good and bad bets happen. But remember, you always have the choice to quit the stock after two consecutive bad bets. So you have the choice to even alter this reality in time dimension!

The Power of Compounding Gets Undermined with Diversification

If you choose the right time and the right stock that means you will consistently make profits and the profits keep compounding. Otherwise there is no point in investing in the stock market. Compounding is its special feature. Those who bet for the first trade only, often miss to understand the power of compounding and even go to the extent of taking loans.

Compounding is a multiplier effect on gains. Every gain will get compounded with the consistent profits that you make provided you bet all of your capital each time. The compounding makes it faster to earn the money that will take a longer time otherwise with fixed income investments.

Even with a little change in the interest rate or profit rate per bet, your net gains after a period of time increases drastically. A 10% profit rate gives you a gain of 159% on your initial capital after 10 successful trades. After the same number of trades, a 20% profit rate gives you a gain of 519% on total capital!

The Last Problem with Stock Diversification

The right term to use for diversification in today’s reality is stock diversification. Because diversification is done only on stock domain by splitting capital into several different stocks. There is a simple problem with diversification that is on the part of the trader than the stock behavior.

When you diversify your portfolio on several stocks, there is now an increased need to focus more. If you were trading only one stock, then you would have to focus only on its behavior or background company. With too many stocks it becomes hard to focus as much as you would have done with only one stock. You may think it is not really hard. But think again and check your past behavior with diversification.

In my trading experience I had always found that I had to close my losing bets till the loss has become unbearable but still take all the loss just to stop watching the blood-shed stock in my portfolio. It also happens that a badly failed stock does not recover as fast as other stocks gain and that in turn wastes the time of investment of your capital.

The focus means to be able to do all the important activities that make the trade successful. They can be alertness during the time period into trading, right decision making with discrimination, looking at percentage numbers at the stock level and total capital level, sticking to the original reason for entry into a stock etc.

Check for yourself. If you see these problems then you should change your understanding and strategies. Don’t diversify just like that. There is a way to use diversification in its right intent that I will explore in the next post.

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