This is a more difficult topic, but one which demands attention from all investors, not just option traders. Much ink has been spilled on the topic of portfolio diversification, wherein it is said that those who trade in multiple different underlyings, can be said to “spread off their risk”. In other words, rather than having all of your eggs in one basket, say, by just investing in Google, you try to invest in multiple symbols at the same time, so that the risk of one symbol is spread off by investing many symbols. But does this really work?
Part of Tim’s shorting strategy relies on investing on many underlyings at once (sometimes), and I assume investing small amounts like $1-2000 at a time so that the gap losses, when they happen, will be small (intraday losses are minimal because of tight stops – when they are employed). However, as we shall see, this is partially a false sense of security.
We see in one study that up to an n of 30, increasing the number of instruments in one’s portfolio does indeed reduce volatility and risk. Standard deviation (risk) initially might be 49% with one instrument, but only 20.9% (a reduction of about 60% of the risk) with up to 30 instruments. However, beyond 30 there are limited returns.
Imagine a morning in late November. A coming of winter morning more than twenty years ago. Consider the kitchen of a spreading old house in a country town. A great black stove is its main feature; but there is also a big round table and a fireplace with two rocking chairs placed in front of it. Just today the fireplace commenced its seasonal roar.
A woman with shorn white hair is standing at the kitchen window. She is wearing tennis shoes and a shapeless gray sweater over a summery calico dress. She is small and sprightly, like a bantam hen; but, due to a long youthful illness, her shoulders are pitifully hunched. Her face is remarkable—not unlike Lincoln’s, craggy like that, and tinted by sun and wind; but it is delicate too, finely boned, and her eyes are sherry-colored and timid. “Oh my,” she exclaims, her breath smoking the windowpane, “it’s fruitcake weather!”
The person to whom she is speaking is myself. I am seven; she is sixty-something, We are cousins, very distant ones, and we have lived together—well, as long as I can remember. Other people inhabit the house, relatives; and though they have power over us, and frequently make us cry, we are not, on the whole, too much aware of them. We are each other’s best friend. She calls me Buddy, in memory of a boy who was formerly her best friend. The other Buddy died in the 1880’s, when she was still a child. She is still a child.