Replies to post #8878 on A.I.M. Users Bulletin Board (AIMUSERS)

[aptus]

Hi J,

"If I understand the academic studies properly, risk is lowered AND returns are slightly better."

Yes, that can be the case. MPT tries to create portfolios that maximize returns for a given risk level or minimize risk for a given return (basically the same thing viewed from two different perspectives).

So if you have a non-diversified portfolio, that has risk X and returns Y, then it's quite possible that a properly diversified portfolio can give you X' and Y' where X' < X and Y' > Y.

"It seems counter-intuitive that a more conservative scheme produces better results but that seems to be the case."

Very well said. Much like quantum mechanics, this concept is not naturally grasped by our minds. It appears to go against common sense. However it has been proven over and over again to hold true.

[Rien]

risk is lowered AND returns are slightly better

I assume that this is valid for LTBH. And thus is also valid for AIM BTB (the "core" position is a LTBH position).

However I do not believe that this applies to all trading methods. Life simply is not that simple :-)

[Conrad]

On the subject of diversification there appears to be a consistent misunderstanding of the subject(by some). On many occasions the claim

Diversification is really just another way of saying lowering risk

is made and various readers eagerly confirm that they believe this to be so.

Diversification as such is not at all a means of lowering risk unless the mix of funds is properly selected to reduce risk relative to a market average. This is precisely the message Mark Hing tries to communicate.

If you select fund unwisely you may pick(for various reasons) only losers and this type diversification might make you go bankrupt before you can blink an eye. On the average the risk of a mix of losers is the same as the accumulated risk of the individual funds.

Compare it to betting. When you go to a casino and you bet on one roulette table then your theoretical risk profile is the same as if you bet on 10 roulette tables simultaneously. It is true that on one machine your can lose all in one shot, but that is due to betting all in one shot and has to do with risk distribution in time rather than risk profile. The same is true if you bet on all the betting opportunities at the same time or bet on then consecutively: In the long run you do not change the risk profile.

In order to reduce risk relative to your current risk profile you are exposed to you ought to eliminate the risk factors you are exposed to. Engaging in a dangerous activity exposes you to the same risk each time and you do not reduce risk by engaging in many dangerous activities. In order to reduce the risk run you might take up midget golf instead, or knitting socks.

So, Risk Reduction in investing can only be achieved by exposing your money to less risk, not to spend it on a bunch of risky investments.

Naturally, if you pick one very risky investment and lose the dough right off the bat that is tough luck, but if you picked 10 losers then you still lose the dough in the end. If you pick one solid investment and it makes you stinking rich then this gain is not because you exposed yourself to risk but the gain resulted from picking a sure winner(that money was not necessarily exposed to any risk at all).

Diversification can, and sometimes does, increase risk. Making good investment choices and then making the amount of the investment dependent on a risk analysis will maximize your profits and minimize overall risk.

Anything else is simply like running around the casino and throwing money at machines at the suggestion of people that have no idea how the Pay Out Ratio is. Reducing risk of losing money in the Casino is achieved by having a few drinks there and observing other people lose their money while keeping your money in your pocket.