Diversification Does Not Lower Risk

"You want to reduce your portfolio risk. Diversify, diversify, diversify..." I remember hearing some stock broker ranting on TV a decade ago, as the bear market hit US in 98 along with the collapse of Long Term Capital Investments. The audience at the studio watched her intently, the pain of recent losses still apparent on their faces. They all wanted desperately a way out of the hole, and turned to this supposedly professional for advice. She kept going with the metaphors of eggs and baskets, how risk is bad... Just exactly how and why, she did not bother mentioning.

The concept never made sense to me even before any exposure to the financial markets. You buy a stock, then you buy some more because you hope they will move against each other, does that not simply lead to low potential returns, if any, and high commission costs?

With the advent of Exchange Traded Funds and the explosion of hedge funds throughout the world, correlations between stocks, bonds and commodities have become much higher than the days of Markowitz (founder of modern portfolio theory). An educated guess points to speed of information between newly developed funds making similar price impacting transactions concurrently.

ING, a fund management business based in Australia, likes their investment advisors boast "safety" of their holdings due to diversification. Look up ING fund unit prices, every single one has declined since the sell off of last July; some have taken draw downs up to 70%. So much for the magic of "diversification" huh? The only logical conclusion pushes that some of these losses would probably have been lessened if they did NOT "diversify" and kill the performance with transaction costs.

Does it even matter why or how this phenomenon has occurred? It simply happens, and knowing it alone could help you become a more informed investor or trader.