Concentration vs. Diversification
In this short article, I’d like to quickly introduce two opposing strategies in portfolio management. Namely concentration and diversification.
What Is Diversification?
I am sure most of you have already heard the term diversification before. Be it while listening to your parents talk about investments (if you’re lucky), some bankers selling it to you as the holy grail of portfolio management, or just a narcissistic prick talking about it vaguely and trying to get some of that sweet attention at a party. Truth be told, it’s really nothing complicated.
Diversification is a strategy that mitigates risk by increasing the amount of held assets. There, simple as that.
As for the why - there is some science here that explains it really well. If you’re interested in the underlying principles of it, I’d encourage you to watch some videos, such as:
Just like 2 assets are never 100% correlated, neither are they 100% inversely correlated, taking into consideration the vast amount of factors that can affect volatility and expected return. The lesson here however stands — by adding more assets to your portfolio, you’re effectively mitigating risk. The question then becomes, how much can we mitigate the risk, and what are the diminishing returns of this strategy?
Here’s a simple way to look at it: The more assets you hold in your portfolio, the more you mitigate risk. However, every new addition to your portfolio mitigates risk less and less. This is called diminishing returns.
Say you’re holding 1 asset, all in, 100% degen mode. Adding another asset to the mix can mitigate risk by up to 50% (theoretical case for two assets that are 100% inversely correlated). However, adding another one no longer mitigates risk by 50%, it’s less this time. And it’s gonna be less and less for every addition.
Diversification allows you to spread your risk amongst more assets so that when one goes south, there are others that keep you alive.
A nice analogy my dad used to tell me — “Be a spider, not a tower. Have more pillars of support so that one hit doesn’t kill you.”
What Is Concentration?
Concentration is the opposing force to diversification. If diversification tells you to put more eggs in your basket, concentration tells you to do the opposite. Essentially you’re concentrating your risk into fewer positions.
But but but isn’t that bad? Hold your horses, before you start arguing that it’s a bad idea overall, let’s approach this with an open mind and see what good and bad this strategy offers.
Holding fewer positions comes with a fair amount of risks. Just like the spider/tower analogy, now you’re vulnerable. The extreme of this strategy would be holding a single asset, which is almost always a bad idea. No matter how safe and sound your analysis of a given asset is, you can never predict everything, as the amount of factors influencing the price of an asset is vast. One of these factors is the chance of a black swan event which could totally ruin you and your little tower.
We are no extremists here though, we want to use this strategy to our benefit. By holding say 3–5 assets, you’re betting big on a few ideas and if you’re right, your chances of aggressively building your wealth are pretty good. And that’s what it’s all about.
While diversification would be considered passive, concentration is aggressive. And as you have probably already figured out, the difficult part is in finding a balance between the two.
Striking A Balance
So when should you use these strategies? And for this question, just like many others, I’ll offer a very unpopular answer — “It depends”.
And it really does. Here are the main factors that will play a role in this decision-making process
1) How much money you have
2) How much money you aim to make
As most people who have succeeded in the markets probably won’t read this, I’ll just assume most readers start off as new investors with very small capital.
In your early stage of wealth building, you should be focusing on a concentration strategy. A perfect example of how that would look like is:
1) Study fundamental analysis in order to understand what assets you’re buying and being able to justify their position in your portfolio
2) Study technical analysis in order to snipe favorable risk/reward setups
3) Pick a small (2–5) number of assets to create your portfolio
These are the absolute basic first 3 steps.
Let’s assume now for a minute that everything goes well and you’re making some money. With assets appreciating in value, they also lose their risk/reward setups. Therefore some profit-taking is to be expected. How do we do that? I call this “rotating the crops”.
Rotating The Crops
If you thought “I can’t possibly ride a few picks for eternity”, then you’re absolutely right. Even with a concentrated portfolio, risk management is still key. There are many ways to manage risk and rotate crops, but here I’ll talk about how I do it.
As some of your assets appreciate, it is a good idea to sell parts of it. By taking profit, you’re locking in a portion of the gains which can then be used in more favorable risk/reward setups.
Say asset A decides to go on a run and starts trending hard. Every time an asset appreciates x%, you decide to sell a part of it.
As a crypto trader, I am used to high volatility. Coins can easily do triple-digit % pumps in a matter of hours and that is what I’m trying to take advantage of.
Every time asset A decides to appreciate in the triple-digit % range within a small timeframe, I sell anywhere from 1/3 (my smallest sell) to the whole position. The higher the % gain, the higher the % of my sold position. The reasoning for this is quite simple — these pumps are not sustainable (in most cases) therefore it is expected that the price will drop again.
Here you have 2 options — either use the gains to accumulate a bigger position in the original asset by buying it back lower OR use the gains to buy into other assets with more favorable risk/reward setups (be it one of your other assets or a completely new one). Here it all comes down to your analysis and opportunity cost.
As you continue doing this on and on for months/years to come, you accumulate more capital, and with that new problems arise.
1) Liquidity issues — with more capital, each of your 2–5 positions will be way bigger in terms of absolute numbers ($). Every time you decide to buy new assets or sell some of your existing ones, the size of the order will be bigger and bigger and it will become hard to go in and out of positions instantly due to the impact of your orders on the market. One good way to work with this is by scaling in and out of positions rather than acquiring them instantly.
2) Trading fees — as your positions become bigger, % based fees will also accumulate way faster.
3) Volatility — as your portfolio grows, having a small number of assets will mean high volatility of your portfolio and at some point, the downside really starts to hurt.
And this is when you TRANSITION from a concentration strategy to a more diversified approach.
The Transition
Once you get closer to your financial goal, you realize that it is mainly volatility that is now proving to be a double-edged sword. Yes, winners are still sweet, but losers hurt a lot more now.
Also, as you get close to your goal you no longer need huge multipliers to reach it. Therefore you become more risk-averse and your focus slowly shifts towards wealth preservation rather than aggressive wealth building. And the best way to do that? Diversification.
Now it’s time to increase the number of assets you’re holding. Your previous 2–5 are now proving to be very aggressive and not so sustainable. The transition is a process, so it does have its stages closely connected to progress. You start off slow with the diversification process. Little by little you start adding assets to your crops, mitigating risk even more. How many assets? That’s really up to you and your risk appetite. I’d say 10 is a good number to aim for early on.
While transitioning from concentration to diversification, you should also aim towards thinking more long-term in your investment approach. Fundamentals now become ever more important, as your expected hold time also increases.
With diversification, your position size is smaller, therefore liquidity problems become less of an issue. It’s easier to scale in and out of positions. Volatility is reduced, as losses hurt less at this point because you’re a healthy spider.
Now for the final few steps towards reaching your financial goals, you’re gonna be more level-headed and patient. After all, you wouldn’t wanna lose all of that wealth you’ve successfully accumulated in your journey.
Applying These Principles In Crypto
I wanted to add one more section where I talk a bit about this problem in the crypto environment. Time and time again, I see people joining our group and asking what to add to their portfolio. When I get to talk to them a bit, they later reveal that they have a small portfolio and they wanna do crazy multiples on it (nothing wrong with that) but they hold 10–20 coins. I mean…buddy come on. A couple of points to this:
1) You’re in crypto — the most volatile and the riskiest of markets. And you wanna “play it safe”? First of all, let me remind you of the golden rule of investing — NEVER EVER put more money into the market than you’re willing to lose. So if you’ve made the leap of faith and decided to go for crypto anyway, why the hell would you want to play it safe? You’re literally risking getting rugged, bugged, hacked, you name it. Crypto is the wild west of financial markets and you wanna play it safe? Yeah alright.
2) Your portfolio is tiny. If you’ve decided to adhere to the golden rule and put some money into crypto, you should already be content with losing it all. Well, why wouldn’t you take advantage of its strengths then? And by that, I mean the volatility that crypto offers even on spot. It is not super rare to see triple-digit % appreciations in a day. Your best chance is a concentration strategy with good fundamentals and favorable risk/reward setups.
3) Crypto is a new and emerging sector and there are many brilliant and kind people around. During your learning journey, focus on connecting with as many people as possible and try to approach your goals in a collaborative manner. If you’re serious about this and you wanna stay for the long term that is.
And that’s it for my 1st article. I really hope this was useful and that you have learned a thing or two. I have a couple of ideas about future articles, but feel free to suggest what you’d be interested in seeing next.
If I feel like I got something to say about it, I will. If I don’t feel qualified/experienced enough, I won’t.
After all, part of having an edge in the markets is knowing what you’re clueless at too.
I wish you all well and may the price action be with you!
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