The Diversification Myth

It is very popular in the world of finance and economics to advise people to diversify. The usual phrase “don’t put all your eggs in one basket” is usually cited as a great exemplification of the diversification principle.

In short, diversification implies the investment on not only one, but several financial instruments in order to reduce risk. This may, or may not reduce profit, depending on the level of correlation between said instruments. Generally however, diversification does carry the partial hedging of the different means of profit. If one financial instrument profits the other loses somehow and this effectively reduces the risks produced by having all your “eggs in one basket”.

For me, diversification is protection, protection from ignorance. When one is not completely aware and confident of what one is doing, diversification is needed as protection, because the outcome seems blurry and unpredictable. If a person knows exactly what he or she is investing in, I mean, know it a hundred percent, then there is no need for diversification, because this will only negatively affect the profits of the first investment.

Since non of us can predict the future, we all need a certain degree of diversification. To what degree ? To what degree are you ignorant ?

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