0

Everyone claims that its very important to diversify your portfolio to reduce risks and increase the possibility of long time profits.

There are basically 3 industry sectors that I know rather well and love. If I look at all my stocks there are about 11 different sectors.

Now my 3 beloved sectors give me an average profit of 30% each year - while all remaining sectors give me an average loss of 20%.

Since my portfolio builds more on my 3 known sectors I'm still able to be profitable.

The problem: When I pick new stocks I tend to select from my preferred industries. Because I know them and they seem to turn out to be better investments for me. On the other hand with each stock from there the concentration risk increases.

Should I value diversification over profits?

  • Diversification lowers standard deviation but it does not ensure long term profits. – Bob Baerker Nov 23 '18 at 21:43
  • @BobBaerker good point. The word "ensure" is suboptimal if we speak about stocks. I've changed it. – Swizzler Nov 23 '18 at 21:48
  • 1
    If you are concentrated in one position, the result is binary. You make or you lose. At that extreme, it's a 50:50 flip for profitability. Diversification is a different story. In that case, the risk is spread across various sectors but it still does not increase the possibility of long time profits. In a bear market, almost everything loses. Gold sometimes correlates, sometimes not, so it's iffy. If you look at the SPDRs for 2008, 9 for 9 losers, down 16% to 55%. Until the end of the bear in March, down 31% to 76% (with DRIP). – Bob Baerker Nov 23 '18 at 22:04
1

If we're taken as given the premise that there is a sector that is giving consistent 30% returns and will do so in the future, then you should put all your money in that sector. So the core issue is how much you trust that the past performance will predict future performance. The Efficient Market Hypothesis says that these results are due either to chance or a very high Beta, or a combination of those factors.

If it's due to a high Beta, that means that you a getting high returns in exchange for very risky investments. In that case, unless you're willing to continuing to press your luck, you should move into other sectors. And if you are looking for high-risk, high-return investments, you should still diversify into other sectors; if you can't find stocks in those other sectors with high Beta, you can look for derivatives with a high Delta.

If it's due to it being luck, then again you should diversify into other sectors. That leaves the third possibility that you've managed to find an amazing rate of return that thousands of people who are experts in finance have managed to overlook. If you really think you're smarter than them, you should keep your money in this sector.

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.