The Problem of Diversification

Diversification has always been a relatively common concept to investors and is certainly one of the first things covered in introductory literature on the topic. In general, diversification can be defined as "a risk management technique, that mixes a wide variety of investments within a portfolio". The basic purpose of diversification is to minimize risk as by spreading your capital amongst a variety of investments one is less likely to be seriously adversely effected by a sharp and unanticipated move in one or a few of the holdings. However, even though diversification has become a very common practice there are still a number of misconceptions and problems relating to its use among proponents of both traditional investment techniques (i.e. fundamental analysis) and those on the technical analysis side. On the traditional side, diversification has created complacency as many investors do not look past any ideas that differ to what they believe to be the one and only sound investment method; extensive diversification across a large number of markets in a net long manner. However, this complacency which is widespread throughout the money management industry has resulted in returns that in the long-term are on average no better than the overall returns of the broad market. On the technical side the problem with diversification is much different, the majority of traders who use technical analysis ignore diversification and too often will trade only a single financial instrument. However, to be truly successful (meaning profitable in the long-run during both bull and bear markets) from either the traditional or the technical side it is essential to abandon the complacency relating to the common uses of diversification (or lack there of, for technical traders) and instead develop more unique and creative approaches to diversification and ones trading strategy in general.