Portfolio Theory, and practice

Even though "Modern" Portfolio Theory is pretty old, and holds a lot of false assumptions around market completeness and diversification, it could be applied practically for a portfolio of positively expected strategies instead of simple assets vulnerable to systemic risk.

Original thoughts
So the original assumption around increasing the number of asset holdings is to lower the standard deviation of return, i.e. "unsystemic risk" (see below).

This is pretty easy to do by simply taking positions in index ETFs.

So what's the deal with the "Undiversifiable or Market Risk"? That includes things like credit risk, counter-party risk, basically everything that shows why buy & hold does not turn out well.

Actual application

Replacing asset holdings with trading strategies that exploit fundamental inefficiencies where systemic risks become opportunities for profit, and all of sudden portfolio theory becomes practical for the real world. It's like running a casino, to minimize swings in revenue, hosting a whole bunch of games helps the Law of Large Numbers kick in just a bit sooner; and everybody's happy.

Focus On A Few And Not "Diversify"

Many successful full time, professional traders engage entire days on one or two stocks or futures exclusively. No matter how little of an edge this practice offers, learning traders should grasp and take up whatever is available.

Floor Traders

On the exchange floors, the same traders engage in the same security day in and day out. This means that over time, their behavior could display patterns and therefore exploited by the retail trader who spends all his/her time on the associated stock or future.

Reduced Transaction Costs

This should be obvious. Operating a successful business requires expenses to remain at the absolute minimum, and so does trading on a professional level.

Reduced Mistakes

Everybody makes mistakes, and they cost money, at least in the amount of transaction fees. Volatility measure errors, fat finger mistakes like buying instead of shorting or keying in the wrong order volume become rare once the trader becomes familiar with the security.

Diversification Is Obsolete

The permanently optimistic analysts on TV or radio still scream about the well aged concept of diversification. The whole idea was created by an academic, not a professional security trader, decades ago. The highly correlated environment today, along with the credit contraction have created risks that were entirely overseen or intentionally ignored to deceive the public.

Either way, logical, profitable solutions always lie within something that the masses do not realize or engage in. At this moment, majority of the publicly uninformed still embrace the concept of “diversified portfolios” to reduce risk; didn’t turn out that way though for the past year, did it?

Diversification Doesn't Lower Risk

“You want to reduce your portfolio risk. Diversify, diversify, diversify…” I remember hearing some stock broker ranting on TV a decade ago, as the bear market hit US in 98 along with the collapse of Long Term Capital Investments. The audience at the studio watched her intently, the pain of recent losses still apparent on their faces. They all wanted desperately a way out of the hole, and turned to this supposedly professional for advice. She kept going with the metaphors of eggs and baskets, how risk is bad... Just exactly how and why, she did not bother mentioning.

Hedging Via Diversification Limits Returns

The concept never made sense to me even before any exposure to the financial markets. You buy a stock, then you buy some more because you hope they will move against each other, does that not simply lead to low potential returns, if any, and high commission costs?

ETF’s and Hedge Funds Increase Correlations

With the advent of Exchange Traded Funds and the explosion of hedge funds throughout the world, correlations between stocks, bonds and commodities have become much higher than the days of Markowitz (founder of modern portfolio theory). Most of the cause points to speed of information between newly developed funds making similar price impacting transactions concurrently. The markets have changed.

While the investment fund industry grows, fund managers of similar sentiment tend to take action concurrently. This leads to unprecedented high levels of correlation between individual stocks, hence resulting in more volatile markets. In present industry conditions, and evident from recent turmoil, the volatility added risk has become effective regardless of diversification.

ING as an Example

ING, a fund management business based in Australia, likes their investment advisors boast “safety” of their holdings due to diversification. Look up ING fund unit prices, every single one has declined since the sell off of last July; some have taken draw downs up to 70%. So much for the magic of “diversification” huh?

Last Words

Does it even matter why or how this phenomenon has occurred? It simply happens, and knowing it alone could help you become a more informed investor or trader. The world changes, so does industries, and it takes work to adapt and stay profitable.

The market exists for the purpose of asset accumulation or reduction. With every transaction you make, the goal should remain to enlarge account size; anything else serves no purpose but noise. Read a few books and learn what risk management actually entails; it will make everything easier.