Over-diversification is a problem in the FX Markets, and admittedly we have fallen victim to this before.
Over-diversification can be a big problem in the Forex Markets, and admittedly we have fallen victim to this before.
Of course we always have naturally structured our FX portfolios with the best of intentions, holding firmly to the notion of “not putting all your eggs in one basket” as common believe. However we discovered that this can sometimes do more harm than good (ESPECIALLY as it relates to the forex markets). It took an outside look from a large fund, and close friends of ours to clearly identify this as one of our major deficiencies at times.
Billionaire investor Warren Buffett famously stated that “diversification is protection against ignorance. It makes little sense if you know what you are doing.” In Buffet’s view, studying one or two industries in great depth, learning their ins and outs, and using that knowledge to profit on those industries is more lucrative than spreading a portfolio across a broad array of sectors so that gains from certain sectors offset losses from others.
He calls what your fund manager is doing buying 100 stocks a vast “over-diversification” that is sure to result in mediocre returns, returns that are less than the market itself because of your fund manager’s fees.
While we do not agree with everything this man says, when he speaks, we certainly still listen.
We typically have 4-7 different FX trading programs we are typically invested in at any given time. Due to the poor success rate and survival rate generally in the FX markets as a whole, successful and talented traders are further and fewer between as we had previously discussed (especially manual/discretionary ones). We noticed the impact one under-performer could have on an entire portfolio over time and how easily it could stifle the portfolio’s overall growth (“one bad apple in the whole daym bunch”).
Over diversification occurs when the effects of an additional strategy diminish more of the profits on the upside versus what it protects from losing on the downside.
For example…a diversified strategy could effectively cut losses down from 6% to 5% but if it also reduces profits from 10% to 8% then it may necessarily not worthwhile in the long-run from a risk:reward perspective.
In the FX markets in particular, quality takes HUGE precedent over quantity.
Each additional strategy we offer for diversification can potentially lower unsystematic risk but also lower the potential for really good returns by watering down the highest quality strategies.
The challenge then is to find the highest quality programs to fit within this optimized model. Provoking the advice of trusted partners has allowed us to assess our situation through a new lens and skim some of the fat from the amount of products offered as a whole.
We strongly advice picking a smaller handful of higher quality programs that appeal to you most when building your FX portfolio vs a big basket of as many strategies as you can find. This is often a personal preference, but we are here to help advise on this.