In investing and trading, diversification is the process of buying positions with capital that is not 100% correlated with price movement during most market environments. Diversification can be as broad as investing in different types of assets or just in equities but in stocks in different sectors, market cap, or countries. In trading, diversification can be in a watchlist, signals, systems, or different trading methods with designated capital for each.
The purpose of diversification is to reduce over-exposure to one stock, sector, currency, asset class or country. The goal of diversifying is to lower the overall risk of a drawdown in a portfolio and also smooth out the volatility of the equity curve of returns. A diversified portfolio can still achieve big returns by having a few huge winning positions in it. This method creates more opportunities for big wins by the magnitude of a move and also caps the risk of loss to one position to the size of the capital allocated to it.
Diversification is both a type of risk management and a return-seeking process through taking multiple opportunities at a time. A diversified portfolio can let winners run and cut losers short to maximize wins and minimise losses or rebalance the portfolio at times to lock in profits and then buy assets in a drawdown.
Billionaire Ray Dalio has said that the Holy Grail of investing is diversifying your portfolio in a manner that reduces risk without impacting returns. He builds portfolios of assets with little to no correlation but doesn’t sacrifice returns. He looks for 15 or more assets that all perform well over time but don’t move at the same time to achieve those returns. He builds all-weather portfolios that have elements of it that should perform through most market environments.
Excerpts from an article by Steve Burns
