Stock Trading Diversification

In discussing the different attitudes of our two hypothetical traders, Peter and Paul, I have tried to share with you the thought processes that make a successful trader.

If you read any of the marketing material from the Financial Planning community or the Mutual Fund promoters, they all stress the principle of diversification.

They say it enhances returns while minimizing risk - Peter believes that ,as Frank Watkins says in his book, Exploding the Myths, 'Diversification is another word for risk minimization, but it has very little to do with making profits.'

As one of the  Worlds greatest Investors, Warren Buffet, has said on many occasions - diversification is simply an antidote for ignorance! 

Diversification for diversification's sake simply means that you will have your money in a lot of Stocks or markets that aren't performing to their fullest potential - some will be rising, some will be falling, some will be going nowhere.

Hardly the best way to run your trading Business is it?

Peter's view of diversification is different to that of the herd - use technical analysis to find several quality Stocks that are rising, then buy all of them in equal dollar amounts to reduce the risk of one Company crashing and taking all of his capital with it. When these quality Stocks stop going up, sell, take a profit and move on.

Why hold Stocks in a Portfolio that are not rising, or worse, falling in value, simply because you want to have some diversification?

If you look at the typical Brokers Portfolio recommendations, they will include Stocks that are in various stages of trends, both up and down. When you ask them why they would recommend something that is falling in price, they tell you, "Well you have to have some diversification. 

And based on fundamentals, it's valued at much more than the Market is quoting it. Don't put all your eggs in the one basket, spread your risk through different sectors, etc. etc."

Peter merely takes the prudent step of diversifying across several quality Stocks that are rising in price. Simple.

Below are some charts of Stocks that Peter found met his criteria - of course, this is in no way a recommendation to go out and buy any of these - they are simply examples of Stocks that met Peter's buy criteria at the time of entry.

They might not fit the buy criteria now, and some have given Peter sell signals, but they will give you an idea of what to look for when a Broker or well meaning friend gives you that 'hot tip' and says you should buy as many of 'such and such stock' as you can get your hands on straight away.

Source: The charts above were all supplied with the permission of Incredible Charts - www.incrediblecharts.com.au

Study the charts above and you will notice that all of these Stocks were trending strongly with small reactions. The moving averages crossed and gave a buy signal - some gave a sell signal early and then another buy signal, and then they never looked back. 

Of course, not every Stock Peter bought rallied like these did. If they didn't, they were sold and the proceeds were used to buy something that had more potential.

These are the types of trends Peter looks for and diversifies into. 

He doesn't buy, hold and hope for profits, based on some imagined intrinsic value that his Broker says the market hasn't identified yet... 

Remember though, if things don't go according to plan, Peter gets out quickly and looks for the next trade - but while the price is going his way, he simply looks for opportunities to compound his position.

"Remember this simple rule", Peter tells Paul with monotonous regularity - "With any Stock you are considering buying, don't buy it or hold onto it if it isn't going up!!"

Pretty simple advice, really...

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