7 Common Trading Mistakes Part 1: Poor Diversification

  • December 20, 2017

    It is true that putting most or all of your “eggs in one basket” increases your chance of hitting it big. But for every happy investor who picks a stock that outperforms the average, there is one who underperforms. For every Apple there is a Kodak, for every Amazon there is a Books-a-Million.

    Let’s look at the math of being concentrated (i.e., poorly diversified) using an example of gambling on a roulette wheel. Let’s assume it is fair roulette wheel with every number offering a payout with zero expected profit or loss. Now let’s compare the performance of two gamblers. A diversifying gambler places small wagers on every possible outcome. A concentrated gambler places large bets on one number. Note that with a fair wheel, every gambler has an expected profit or loss of $0. The concentrated gambler is likely to gain or lose a lot of money. But the diversified gambler takes no risk. Since all the gamblers receive the same expected payout ($0), the concentrated gambler is simply taking risk for no return.

    Of course in casinos people like taking risk. But in wealth management, risk is an enemy that should only be tolerated when it comes with the reward of higher expected return.

    Major financial markets such as the U.S. stocks market tend to be quite efficient – meaning that stocks tend to offer identical risk-adjusted returns. So the analogy to roulette gambling applies. People taking large bets on particular outcomes take a lot of added risk without enhancing their expected payoffs. Diversified investors take far less risk – yet receive the same expected payoffs of everyone else. Taking less risk while having access to the same expected payoffs is the reason why diversified investing is a smart bet compared to concentrated investing. Being poorly diversified is a common and misguided mistake.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>



1256 contracts, 2010, 401K, adp report, Advisors, Alexandra Twin, alternative investments, annuity, asset allocation, asset classes, asset management, Associated Press, away, banks, Barrons Top 100, BCA, BCA. Biltmore Capital, Ben Bernanke, Best Week, bias, Biltmore, Biltmore Capital, Biltmore Capital Advisors, bond market, Brand, Brand Recognition, Business, Call, CFP Princeton, changes in market price, Chief Investment Officer, closed end funds, CNBC, CNBC Halftime Report, CNN, CNN Money, CNNMoney, CNNMoney.com, collar stock, college grads, Consumer Confidence Report, correlations, Covered, Covered Call Options, credit ratings, customized investment strategies, Dean, donald chambers, Dow Jones, dr don chambers, drop, Early, easy trading, economic policy, economy, Edge, efficiency, election, end, equilibrium, equity trading, etf, etf trading, ETFs, euro, Europe, Europe debt, European debt crisis, family office approach, federal income tax, federal investment income tax, Financial, financial advisor, financial crises, financial distress, financial management, financial security, financial strategies, Ford, Fox, Fox Business, fund manager, futures contracts, Gains, General Motors, Global, global market, Global stocks, groupon, halftime report, Herbert Lash, high income tax, home country, Home Sales, housing market, IDEAS, income tax, income taxes, initial public offering, Instant View, investment bias, investment income, investment returns, investment risk, investment strategies, Investors, IPOs, IRA, Jilian Mincer, Jonathan Cheng, KANA INAGAKI, key, large losses, long risk exposure, Los Angeles Times, make money, making investment money, making money last, Manufacture, Manufacturing, Market, market news, market price, market volatility, Markets, marketwatch, MICHELE MAATOUK, Mike Miliard, Molly Vernon, money, Money Manager, money managers, money strategy, municipal bond interest, municipal bonds, nassau club, New Jersey Advisors, New York Times, NJ, NJ advisors, NJ financial advisors, NJ money manager, NJ wealth advisor, NJ Wealth Advisors, obamacare, oil slide, Options, options strategies, Outlook, outperformance, Pending, personal financial services, personal risk analysis, Play, portfolio manager, Potfolio Manager, Princeton, Princeton Advisors, Princeton asset management, princeton financial advisors, Princeton Money Managers, Princeton wealth advisor, private wealth management, rally, recession, Recognition, registered investment advisor, Registered Investment Advisory Firm, retirement, retirement strategy, return, returns, Reuters, reward, RIA, RIA Princeton, Risk, risk exposure, riskier, rmd, Roth IRA, safer, saving taxes, savings, SEC-registered, Seeking Alpha, short risk exposure, Shudder, signals, skype, social security, social security benefits rules, star ledger, state income tax, Stephen Bernard, Stock, stock market, stock market returns, stock market winners, stock option strategies, stock price, stock prices, stock research, stock strategy, Stock Volatility, Stocks, structured notes, Stuart Day School, swine flu, tail risk, Tax Advantaged Investments, tax free investments, tax savings, tax strategy, taxes, taxes for social security, taxes on investment income, The Dean, The Wall Street Journal, Thomson, Thomson Reuters, Tick, Tim Ralph, Timothy Ralph, Today, Tony Roth, Trading, tricks, Tyler, tyler vernon, U.S., U.S. dollar gains, U.S. Stock, unemployment, USA, USA Today, VIX, volatility, Wall Street, wealth management, wealth manager, wells fargo, world market, worth, Yahoo, Yahoo Financial,