Diversification in trading and investing

How to diversify in investing?

Diversification is a crucial concept in the world of trading and investing, at least from a point of view that is recommended to the average investor, who is, after all, the prototype of the retail investor like you and me.

This is why the great majority of specialists in the investing world recommend diversifying in stocks, from 10 to 30 or 50.

Besides, remember that even Warren Buffett said once that investing in some ETF of index fund was the best thing a retail investor could do.

As Burton Malkiel explains very well in his work, there are Warren Buffetts, Lynchs or other, but the chance to find one when they are young and stick to their investment is extremely low for a normal person.

The problem of finding Buffett of Apple or Microsoft is that the majority of people buy them when it is too late to become rich.

Diversifying investments

For instance, Microsoft has had regular profits since the year 2000, or Warren Buffett has been 15 years with a profit similar to that of the S&P500.

Who knew what Warren would do 40 or 50 years before?

Nobody.

However, the objective of this article is to discuss the fact that any long-term investment portfolio should be well diversified, whether in individual stocks or indexes, plus some bonds or real estate.

Diversifying in stocks and General Motors bankruptcy

About this issue there is one anecdote that comes to mind that belongs to the work of Malkiel, “A random walk..”

At the end of the book, Malkiel gives us three choices of portfolio, one for a 25 year old, another for a 40 year old and another for an old man.

From Malkiel point of view the young should be more aggressive and the old man more conservative.

But the example I am talking about is the mature man, of 40ish who had a job at General Motors and most of his savings in stocks of the company, in that case 219,000 dollars.

The version of the book I am talking about was from 2005 when GM (General Motors) was quoting decently.

What was this man problem?

That he was not diversified.

He could have had a portfolio with 20 stocks of 11.000 dollars each stock, or having an index fund, or ETF.

The problem is that all his savings were in the company he used to work all his life for.

As many other cases in the history of investing this one ended in total disaster since four years later, around 2009, General Motors had to declare bankruptcy, having lost most of its capitalization and its price falling from 90 to some cents.

The owners of GM stocks lost practically all their money.

In 2010, thanks to a government rescue package GM could survive in a very rancid case of crony capitalism. Nonetheless, the old stockholders were annihilated.

That man saved his job but lost his savings.

This example should help us to see that putting all our eggs in the same basket is not a very good idea sometimes.

It is true that we could also have chosen Apple or Google and multiply our investment by 100 but we could have chosen General Motors, Bearn Stearns or Nokia and lose a lot.

Cases like those are many, especially of employees from companies that go bankrupt. Some of them would better buy some different stocks and diversify.

Trading and diversification

Other aspect of diversification is related to short-term trading, where there are a lot of people trying to specialize in an asset thinking that by doing so will discover the “way it works”.

The reality is that the majority of assets behave in a very similar way, in the sense that they have “hot” and “cold” years, so to speak.

There are assets, like gold, that moved very strongly many years with an upward trend, being a blessing for short and medium term trend traders.

However, from 2013 to 2015 the price barely moved trading in a sideways market, resulting in the fact that strategies valid for 2010 and 2011 were not good later.

The same can be said of so many other instruments.

In different years the trading conditions change a lot.

That is why it is good to try a little diversification in assets when trading for the short and medium term.

For instance, it is better to trade a “portfolio of stocks” in the short and medium term than only one, since that one could well be in a stagnating moment and not move during many years, resulting in a disaster for the trading plan

Why diversifying investments?

Whatever you do in trading or investing, try to diversify.

Evidently, a small portfolio with a few thousand bucks will not be able to diversify a lot in different stocks, but it will be able to buy index funds.

Diversification makes that the number of tears and future problems diminish quite a lot.

We will be, therefore, far from the mentality of “all or nothing”.

On the contrary, diversification, especially in long-term investing usually gives us a type of investment, we could call: “quite investment”. Although, it is difficult to be quiet when the market has fallen 80%.

However, when we invest in stocks for the long run it is better to be in peace of mind since in the worst case scenario, with stocks going to zero, you can be sure that the rest of the investment spectrum would not survive either.