Discussion in 'Risk Management' started by oraclewizard77, Jan 22, 2009.
Short-term trading IS diversification.
Unfortunately most who timed the market usually got it wrong.
Just make sure you don't put all your eggs in the day trading basket. It is as bad as putting your entire worth in one position - relying on one strategy, one method....
Diversification is always a good option. You must have heard the famous saying "Don't put your all eggs in one basket"
If done properly diversification can come to your rescue in tricky times as your risk gets spread across varied assets, instruments, strategies, markets, etc.
Darvas is wrong about that, or at the very least the way he's expressing it there is misleading to people, and he may well be misleading himself (as surprisingly many people do, over simple statistical points, by completely overlooking something inconvenient to their existing perspectives).
As so often, the problem with his logic is with the causation: it's the word "since" that's misguided, and therefore the whole logic is. He's using the same woolly thinking, there, that he sometimes criticized in others.
Even accepting that the first sentence is true, the idea that because only 3 or 4 will produce big profits (typically true) the remainder will "drag the performance down" is sloppy thinking of the worst kind: it will drag the average performance down, yes, and it's easy for the reader to imagine that that's all he's contending, but it isn't. What he should realize, and say, is that it would be better to buy just the 3 or 4 stocks that turned out to produce the big profits, but of course that misses the point that one didn't know confidently, in advance, which ones they'd be, without the benefit of hindsight. So it's true that diversifying is worse than "magic, hindsight-based selection", but since that isn't actually available to any of us, it's not exactly relevant or helpful to point it out ... particularly when - as there - he does so to try to imply something well beyond what's actually true!
He's just wrong that diversifying over a large number of stocks doesn't mitigate risk: of course it does - it mitigates selection-risk, and increases the probability of covering whichever 3 or 4 might actually turn out to produce big profits.
Even some reasonably "established"/"respected" authors repeatedly fall into these "sloppy thinking statistical traps" with what they write about trading, and Darvas (for anyone who puts him in that group!) is certainly no exception.
"A little knowledge is a dangerous thing."
Come to think of it, that is the exact strategy of venture investing, instead of starting one company, you invest in multiples and once in a while you catch a GOOGL and the rest is history.
I have done quite a bit of back testing of different trading strategies and have come to believe that a portfolio of 7 to 8 stocks is optimum. Diversified to a point but not overdiversified.
My personal strategy is not to have any losing stocks in my portfolio. It works for me and has handily outperformed the S&P for the last 10 years.
Being well diversified didn't help in 2008. Having a strategy to get out of the market did.
Again it is anecdotal but my strategy had me in cash in the fall of 2008 during the last market meltdown.
Why would anyone hold a stock that wasn't performing the way you wanted it to when you bought it?
It depends what you were diversified in. I happen to think diversifying into uncorrelated asset classes works wonders. You have trade both ways however.
They way most of the top earning stock traders diversify is by having a portfolio both long & short, typically weighted heavier with the primary trend. The number of stocks they hold is much lower than most would think.
Your world class independent stock traders typically hold a long/short portfolio of no more than 4-6 stocks. They still are not risking more than 1-2% of their capital per trade. These traders are somewhat in sync with the Kelly Criterion even if they are not using it.
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