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.
While most money managers will attempt to attract new clients with pitches about how their great diversification and portfolio management will lead to smooth long-term returns exceeding those of their competitors, the truth of the matter is that investing in the traditional manner as so many in the money management industry do, on average only does as well as the performance of the overall economy at best. That being said it should not be overlooked that traditional investing methods can produce decent returns if the economy is growing strongly, which is why it has become so popular, but if the economy is contracting or stagnant over a long period of time investing in this manner will not be very profitable at all. The only way an investor using traditional methods will be able to consistently produce greater returns then the broad market is if they have an incredible knack for picking companies, market, or sectors etc.. that outgrow the overall economy. While many investors will tell clients that they (or the company they work for) have this great ability, the fact of the matter is that the reason why the vast majority diversify in the first place is because they do not. If an investor truly has an uncanny ability for picking investments that will outperform then they will not have much of a need for broad diversification, as they will be better off investing in the strong areas they have discovered. Interestingly, this is in fact how Warren Buffett initially made his fortune, as contrary to popular belief when he first started investing his money was not diversified among a wide variety of companies but instead invested heavily in a small group of companies he believed had very strong growth potential. While obviously very, very few people have the ability to become a Buffett, this does not mean that they cannot attempt to improve the traditional methods which historically perform quite poorly during bear markets or times of prolonged economic decline or stagnation.
What makes the traditional investing and diversification method even less desirable then what proponents make it out to be is the fact that in the vast majority of instances money managers using these methods are essentially long on almost all their positions at all times. What this means is that when confronted with a broad bear market (such as the one in 2008) where virtually everything goes down a diversified net long portfolio will not be beneficial at all. Instead accounts structured this way will see returns in line with the markets, and in some cases even worse, which after the 2008 bear market meant a substantial loss. Therefore, if one is attempting to achieve returns that consistently exceed those of the broad market they must seek out ways to overcome the problems that tie traditional diversification to the returns of the market, and without exception this is what the extremely successful investors have done. Be it an investor like Buffet who was able to determine which companies had the greatest prospects for growth and then investing heavily in them, or be it investors who study the macro conditions of the economy and are better able to anticipate times when a net long portfolio is a detriment and thus act accordingly. However, while grasping the problems associated with the traditional method is fairly easy, actually developing a strategy to consistently produce positive profits over the long-term is extremely difficult and only achieved by a very small percentage of investors. Furthermore, a likely reason for the continued popularity of traditional investment methods is that if executed correctly one will rarely experience a swift and drastic decline in capital, and that is more then can be said then for some of the foolish ways certain individuals attempt to make a fortune on the markets.
The problems that tie traditional investment methods to the returns of the broad markets has led many individual's to technical analysis, with that number continuing to grow due to advances in computer and internet technology. Interestingly, unlike traditional investors most technical traders and especially day traders have a preconception that technical analysis does not require much if any diversification and instead one can be successful by trading a single system on a single financial instrument. However, this preconception is a large contributor to the fact that the majority of technical traders like their traditional counterparts do not see returns consistently exceeding those of the broad markets. In fact, unfortunately technical traders (and again especially day traders) who maintain this dangerous preconception are less likely to experience returns close to those of the broad markets like those investors following traditional methods, but instead are more likely to experience various routes (sharp swings in capital, extended sideways movement, or even incredibly swift and sharp losses) all of which more often then not lead to a voluntary or forced ending to ones trading career. This is why a technical trader who is determined to become successful must overcome this preconception and realize that along with a tendency to over fit ones system to historical data, the lack of diversification plays a significant role in a majority of technical traders lack of success. Diversification for technical trading does not mean simply adopting the traditional diversification method and trading ones system on a large variety of financial instruments, but instead is comprised of two main elements; firstly it requires the use of multiple technical systems, and secondly requires trading more than one financial instrument.
The first element, using more than one system, is not often considered by technical traders but is crucial for long-term success. As was already mentioned too many technical trader are stuck on the belief that one needs to just develop a single set of rules for entering long and short positions and then they can just sit back and watch the dollars roll in. However, not surprisingly, what really happens to traders with this mentality is that after developing a system and back testing it on historical data, when they actually begin trading real money they soon (and sometimes right away) find that the system produces nowhere near the returns that they had expected. Now there are certainly situations where an individual will get "lucky" and start trading a single system only to experience significant profits, but more often then not this turns out to be a curse rather than a blessing. These "lucky" traders often become overly confident in their one system and when it stops working they are too blinded by their prior success to abandon it or change to a system that better fits the new market conditions. And it is because market conditions change over time, or in other words due to the fact that the markets exist in various states throughout time that require the use of multiple systems. For as anyone who has spent a significant amount of time developing technical trading systems will know, creating a system that is robust enough to be profitable during all the different market states is extremely difficult.
There are four basic market states each of which is driven by a different collective psychology of market participants and as such requires a different system or set of rules to be profitably traded. The four main states are an up-trending (bull) market, a down-trending (bear) market, a sideways range bound market, and possibly the most difficult to trade, an extremely volatile sideways moving market (like range bound but with much sharper moves). If one examines price movement during times when the markets are characterized by these different states they will quickly see that each requires a different set of entry and exit rules to achieve strong profitability. For example, a simple system based on something such as entering on the break of new highs or lows may work well in an up-trending market, but during a range bound market will perform extremely poorly. Furthermore, one may be inclined to believe that a system that works during a bull market will work equally well during a bear market, however, this is not always the case as the psychology behind the two differs. A bull market is primarily driven by greed and/or complacency (depending upon its length), while the psychology behind a bear market is primarily fear, and fear definitely produces different price movement then greed and/or complacency and is why bear markets are usually much more swift and dramatic then bull markets.
The need to trade a multitude of systems invariably brings a technical trader to the question of how to know when to trade which system, and overcoming this separates the extremely successful technical traders from the rest of the pack as there is no simple answer. However, logically there are two obvious ways one could potentially overcome this problem; firstly, one could try to develop systems that when traded during the market state to which they match are extremely profitable, but when traded during states to which they do not match only produce slight losses, or even better are near break even. If one is able to develop systems in this manner they can trade all their systems at once as the systems that match to the current market state should hopefully produce profits that greatly exceed the small losses of the other systems. The second way to attempt to overcome the problem of when to trade what system is for one to develop a method for accurately determining when the market state has shifted and then changing the system they are trading accordingly. Which of these methods, if either, is better is certainly up for debate, but what is not up for debate is the fact that to overcome this challenge is extremely difficult and requires immense amounts of hard work.
The second element of diversification for technical traders is trading a variety of financial instruments and while obviously the easier of the two elements to implement, it is still very important. By trading a variety of financial instruments across various markets, sectors, and industries one is more likely to trade a financial instrument which is in the correct state to be profitable with one of their systems at any given time. Trading just a single financial instrument means that a trader is tied entirely to the movement and state of that one instrument, and if it enters a prolonged period of tight range movement, or extremely volatile sideways movement it may be very difficult to earn profits. Similar to the reason that traditional investors diversify, technical investors also benefit by not being too heavily reliant on one or a few financial instruments. However, unlike traditional diversification it is probably not as important or reasonable for a technical trader and especially a day trader to be spread out amongst too many financial instruments as they may soon find it difficult to monitor and execute orders in a correct and timely manner. Instead what a technical trader must do is find a good variety of financial instruments that if possible are not too correlated to each other (obviously this can be difficult during sharp bear markets), that have all historically performed well with the systems that have been developed, and finally that fit the traders level of capital and risk tolerance.
To conclude, while diversification is a very common concept among participants of the financial markets the manner in which the majority of investors and traders use it is quite limiting. That being said it is essential for anyone who is considering trying new and innovative ways of investing to understand that there are a lot more creative ways to quickly lose your money then there are to make money and as such careful, dedicated, and a lot of hard work is required. An investor who attempts to develop a new strategy will inevitably face many failures, setbacks, and times of severe frustration, but those who are able to make it through these difficult stages without losing their trading capital will greatly increase the chance that they will be one of the very few who actually achieves great success on the markets.
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