How Diversification Actually Works

Kanin D. Alldredge, JD, MSQE

Legal & Quantitative Analyst / Author / Educator, The Currency Classroom

Free

Diversification is one of those words used so often it has stopped meaning anything. So let me give you the actual definition, because it is stricter than almost anyone applies it.

Diversification is owning things that do not fail at the same time.

That is it. Read it again, because the second half is the whole thing, and the second half is what people skip.

Here is the mistake I see most often, and it is an honest mistake.

Somebody holds several currency pairs and feels spread out. The euro against the dollar. Sterling against the dollar. The Australian dollar against the dollar. The dollar against the yen. Different continents, different central banks, looks like a portfolio.

Now look at what they have in common. The dollar is on one side of every single one of them. That is not several positions. That is one position, expressed several times. When the dollar moves, they all move together, and the account that felt diversified turns out to have been concentrated the entire time.

So the question is never how many positions you hold. The question is what they all depend on.

Ask it plainly: what single event would hurt every one of these at once? If you can name it, you are not diversified. You are repeated.

Now the part that gets left out of every brochure.

Diversification lowers how violently your account swings. It does not raise your return. Spread across enough things, it lowers it.

That is the trade. Anyone telling you otherwise is selling something.

So here is the honest version, and it is the one worth keeping.

Diversification protects you from being wrong about one thing.

It does not protect you from being wrong about everything, and no arrangement of positions ever has.