Trading What You Know: Finding Your Diversification Center

Learn the possible limits of diversification and how to potentially diversify in a way that's not just checking a box.
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Drink your milk. Have a firm handshake. Diversify your portfolio.

Everyone gets some free advice as they move through life, and most investors remember that last one. Like our parents’ warnings to put on sunscreen, the lesson of portfolio diversification tends to stick with us.

Diversification has its place if you believe in the old adage of not keeping all your eggs in one basket (another piece of advice you’ve likely encountered). On the other hand, some of us might get too caught up trying to diversify our portfolios and aren’t focused enough on trading the areas of the market that we know best. This can mean squandering some of our investing opportunities. While we don’t want to keep our eggs in one basket, it’s also important not to buy baskets with holes in them.

The lesson is to diversify, but not in a way that’s like checking a box. As traders and investors, we often learn about the markets and find ourselves growing more knowledgeable about some sectors and instruments, while understanding less about others. Consider trying to take advantage of those strengths and allowing your portfolio to benefit from your experience.

“Some people buy shares of a company with an unfamiliar business model, just because it’s a blue chip and they want to diversify,” says Harrison Napper, product manager at TD Ameritrade. “But by doing that, they could be losing their opportunity to do well in companies they know. There are benefits to diversification. But you should still apply the same type of discipline you would to any other trade.”

Diversification for Diversity’s Sake Doesn’t Always Work

Napper recalls one investor who learned from a trading program that he wasn’t diversified enough across sectors. The program encouraged the investor to consider investing in some sectors where he didn’t have as much exposure. He promptly bought shares of some large stocks in those sectors, not really knowing the fundamentals but assuming it was an appropriate way to diversify. However, the stocks tanked soon after he bought them.

“Diversification is good,” Napper says. “But there’s diversification that isn’t mindful.”

Napper believes many investors are less than mindful about diversification. They’re told to make sure a certain percentage of their holdings are across lots of sectors to help minimize risk, but they end up having investments in many areas they don’t know well.  

“Diversification can actually increase risk, and increases alignment within the target sector or market,” Napper says. “Increasing investment across more companies in a given sector, for instance, will cause aggregate performance to mirror the sector more and more.”

A mindful strategy might involve devoting more of your assets to shares of companies where you have a better sense of the company and industry, even if that means ignoring that proverbial eggs-in-a-basket advice. It brings to mind one famous investor’s advice to trade what you know. Or, to put it in Wall Street terms, consider leveraging your strengths and hedging your risks.

Leverage Your Sector Knowledge

Assume, for instance, that you’re knowledgeable about the info tech sector and see it going higher but think the stock market as a whole is overbought. You could leverage your knowledge by going long on info tech stocks while at the same time hedging the broader market with put options. That’s arguably more mindful than simply spreading your assets evenly across lots of sectors and hoping the law of large numbers will ultimately give you a statistical performance that mirrors the market.

 “If you have high confidence in a trade, and practice over time, you don’t have to underallocate to something you have confidence in and overallocate to things you have less confidence in for the sake of diversification,” Napper says.

One other thing to keep in mind about diversification: make sure you understand the relationships of companies you own to one another and to the market as a whole. You can often end up thinking you’re diversifying when, in reality, you’re not. For example, Amazon (AMZN) is classified as retail, and Alphabet (GOOG) as software. If someone were thinking about buying $10,000 of GOOG but instead bought $5,000 of GOOG and $5,000 of AMZN to reduce exposure to technology, that trade might not align with their actual objective. That’s because AMZN is a stock that to some extent reflects both sectors.

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