Fine-Tuning Your Risks by Dirk Vandycke
Beyond The Obvious
In this second of a two-part series on managing risk, we look at how to overcome the disadvantages of diversification.
In part 1, it became clear that we need to bring profits and total return into the equation to evaluate the effects of diversification. However, itís necessary to look beyond its common risk-lowering incentive and gain a more holistic view of diversification. While the advantages on the risk side are beneficial to all traders, from expert to layman, you mustnít be blind to the disadvantages, mostly on the profit side. Diversification will spread risk, and hence lower it, but at the cost of averaging your returns. Letís see if we can put this knowledge into practice.
DIVERSIFICATION vs. CONCENTRATION
Statistical expectancy tells us we have more control over the average size of winners and losers than over how frequently they occur. But frequency plays a role in profitability, so instead of trying to increase the numbers of winners while decreasing the number of losers, perhaps you should shift your focus to minimizing the size of losers and maximizing the size of winners.