7 Common Trading Mistakes Part 1: Poor Diversification
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.