Levels of Diversification

One of the first pieces of advice people are exposed to when entering a market is to diversify their portfolio. Diversification equalizes risk allowing one to possibly purchase highly volatile investments while at the same time, balance that out with more conservative ventures to tailor the overall risk to what is appropriate for them. However, another way to go about this is to only purchase investments with the target risk one has in mind. In this case, we have achieved the same outcome by not diversifying our portfolio at all. So, does that mean diversification is something that is well over-hyped and optional to partake in? Not necessarily.

We must realize that diversification can be thought of like an onion, possessing many layers, with each subsequent layer carrying a different and more specific kind of risk. It is unlikely that a homogeneous approach will be taken for each layer, and as such, diversification should always be on the back of one’s head as a tool for balancing risk. Take for example, Bob has $5000 and is just starting off with investing. He looks at his options and sees interest in: the stock market, government bonds, and cryptocurrencies. Let’s say bob has an aggressive stance on investing, tolerating high risk (8/10) for a potentially humongous return. For Bob’s portfolio, he could maybe dedicate 30% of his capital to the unregulated and highly volatile crypto market. He could dedicate 40% of his capital to the more regulated but still risky side of the stock market while his remaining 30% could be put into government bonds to keep himself grounded and balance out his participation in the cryptocurrencies. What Bob could also do to possibly achieve this level of risk for his portfolio is to invest 100% of his portfolio into stocks. From a risk perspective, both options are valid routes and the choice between which one all depends on what Bob is really interested in and how he personally feels about each market.

Let’s say Bob now decides that he will take the first option and diversifies his funds between crypto, stocks and government bonds. Now what? What Bob should really do is to then partition groups of investments within each major branch and assign risks for those so that he can achieve his subsequent set of diversification. Focusing on the crypto market, he can partition it into the some possibilities such as sector (privacy, entertainment, utility etc.) and market cap. Market cap provides more of a direct relationship to risk as it mirrors that of a traditional stock market. Large caps will provide smaller risks where as small caps (but really ICO’s) are on the complete opposite end of the spectrum. That being said, Bob can therefore achieve a subsequent level of diversification by allocating chunks of his cryptocurrency funds between these various partitions to further tailor his risk towards his portfolio. It is important to note that again, depending on what Bob’s risk is, he could end up putting all of his money into large, medium or small caps.

Let’s say Bob decides it is sufficient enough for him to stay relatively safe so he puts all of his money into large cap coins. He will then have to finally decide which coins he will want to dump his money into to settle everything. Much like the previous steps he has the same options: put everything into one basket or diversify.

I think you get the point now so I won’t be elaborating much more but what I will say is risk management peels like an onion and even though you could get away with putting all your eggs into one basket at one level, it is unlikely that it will happen through subsequent ones. Thought processes like this is partially what separates an investor from a gambler. An investor knows how to perform adequate risk management through meticulous allocation of funds to fit his own profile whereas a gambler simply tosses his money up in the air hoping for luck to purely boost his monetary gains to heaven and beyond.

Happy trading!