Over-diversification is a problem in the FX Markets, and admittedly we have fallen victim to this before.
Hello – my name is Alex and I am an over-diversifier!
We have always 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 belief. However we discovered that this can sometimes do more harm than good (ESPECIALLY as it relates to the forex markets – above all others, as it is generally regarded as one of the more difficult markets to trade). It took an outside look from a large fund manager, 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 (at best), and 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 that we are heavily invested in at any given time and many more that we have smaller investments in. Due to the poor success rate and even poor survival rate generally found in the FX markets as a whole, successful and talented traders are further and fewer between as we had previously believed (especially manual/discretionary ones). Further, while building portfolios, we noticed the impact that 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 mathematical, and a risk:reward perspective.
In the FX markets in particular, quality takes HUGE precedent over quantity.
Each additional strategy one introduces 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.
While we offer many products, this does not mean you need to invest in them all! Please be mindful of correlation, and the potential for bad apples when building a portfolio. This is what we are here for to help our clients structure a good portfolio.
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. Also, you can weight your portfolio as well whereby you can allocate more capital to your preferred strategies, and less to your less preferential ones.
Portfolio building is of course something that is highly personal and there is no once size fits all. Be smart and be safe, and take note that a good non-correlated portfolio of 2-3 solid FX strategies is quite often all that is required to consistently profit in the FX markets.
We strongly suggest taking Buffet’s words above to heart in the FX markets. Don’t over-diversify, and don’t over-complicate things.