For long, diversification or holding a few great stocks simultaneously has been promoted as the most optimal way to maximize stock market gains while keeping losses to a bare minimum. However, recent empirical evidence is showing that diversification may not be as effective as originally thought.
According to research, diversification—especially one driven by correlation—is not all that effective at minimizing losses in times of a stock market crisis. In fact, in some cases, diversification of stocks has resulted in losses as high as 50%. It has been found that the benefits of diversification are not due to the diversification of stocks rather they are a result of de-risking.
A research paper titled ‘The Free Lunch Effect’ indicates that the lowered risk that comes from a move to a balanced portfolio from a portfolio comprising of only stocks is simply due to the less volatile nature of bonds compared to stocks.[ However, this does mean that de-risking comes without merits. In fact, one of the easiest ways to lower risk potential is de-risking a portfolio outright.
However, the problem is that you cannot reduce risk through the diversification benefits and maintain a return profile at the same time. This goes against what a lot of people believe is true. It disapproves what stock market traders and the so-called ‘experts’ have been telling us for decades. According to them, diversification is the answer to all our problems in trading stocks. It is not!
Why Diversification is Not the Answer!
For too long, financial professional and trading ‘experts’ have been selling diversification as the be-all and end-all of stock market trading. However, what they have failed to do is discuss and debate the dangers of excessive or ‘too much’ diversification of stocks.
It is no less than a crime to acquire and hold more assets than what you can reasonably monitor. Yet, we don’t find many people debating the problems and dangers with excessive diversification. A study by Page and Panariello has found the nature of asset correlations to be bi-modal. Bi-modal refers to having or involving two modes.[ The dynamics indicated by the study by Page and Panariello is not in line with most stock traders want to see.
According to the study, while there are several opportunities unlocked by diversification when the market is behaving positively, correlations only tend to go in one direction during a stock market crash or crisis.
Let me be clear. Although the study does not paint a rosy picture of diversification in stock market trading, diversifying stocks is not outright worthless. It is just insignificant in the grand scheme of things. If you want to trade the stock market better, then you will need a better approach that truly minimizes your risk and creates growth.
An approach that fits this bill perfectly is automated trading or AI investments.
Most people think that diversification is their best bet to profitably trade the stock market. However they don’t know any of the alternatives. An emerging technology that has only been accessible to professional traders and institutional billionaires is automated trading or AI investments. Most people don’t realize that automating trading or AI investments creates a risk management system that hedges your bets. How does it do this? AI investing automates your portfolio and risk management for you. It makes the trades by selling or buying stocks when it senses risky situations or high growth circumstances and holds money in cash to protect it during volatile times. On the other hand, diversification assumes that a person knows that not everything will go down during a crash or market drop, which is clearly not always the right approach to investment stock trading.
iFlip is the first company to bring Algorithmic intelligence (AI) trading software to the regular consumer. This means it does everything for retirement and investment accounts. Setup only takes 1hr to do. They’ve found a way to automate everything from technical analysis to on-demand trading execution. This means that iFlip’s AI or automated trading software does not need human involvement or diversification to ensure a profitable stock trade ROI for its clients.