According to Investopedia: Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most cost-effective amount of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate. Why It Works for Stocks Stock investing is a microeconomic view of the markets. Corporations specialize in creating or servicing various niche markets. As an investor, it makes sense that you don’t place all of your eggs in one basket by being overly exposed to one sector. By having shares of various companies, you are able to gain the benefit of multiple sectors, and hopefully they do not correlate with each other. There are tens of thousands of stocks out there, and for the lay investor it is difficult to pick and choose which ones are exactly right for your portfolio and to what degree you should be invested in them. The quick solution has been the mutual fund. By allowing the mutual fund to set up the 25 to 30 essential stocks, an investor is able to get into the market with little thought. There are aggressive to hyperconservative mutual funds available. Each mutual fund has its own pros and cons. At the end of the day, it is far more accessible for the everyday investor. If you purchase one share of a mutual fund, you have full access to the 25 to 30 stocks in a fully diversified portfolio. There is also a new trading investment called the exchange-traded funds (ETF). It basically operates like an index, but it is traded just like a stock. The price fluctuates daily and is often more accessible than mutual funds when it comes to price. ETFs are a revolutionary way to diversify investor accounts with little planning, but still have a big impact. Between traditional mutual funds and ETFs, investors are able to take a microeconomic investment like stocks and have an immediate exposure to a macroeconomic-type diversification. Why It Doesn’t Work in Futures and Forex There are two schools of thought when it comes to futures and forex investing: diversification and specialization. The proponents of diversification feel that contracts in various markets will increase your opportunity to profit. The problem with this theory is the too-often-ignored inherent dangers—varying leverage of markets and macroeconomics. First, the various leverage amounts of different markets can have a significant impact on how you profit and lose in your trading. While the British pound may gain or lose at the rate of $6.25 per tick, gold gains and loses at $100 per $1 move. The speed at which you are gaining and losing in multiple markets can make it difficult for you to be “equally” diversified in various markets without having to significantly develop a weighing system that matches the gains and losses for each market. This problem has often been found when companies develop various futures commodity indices. It is very difficult to attempting to give equal weighing to corn and oil, particularly when they move at different speeds and return different gains and losses at differing price movements. The second problem is a bit more insidious and is a little more difficult to deal with. While each stock represents its own universe of corporate governance and success or failure in relation to the sector it is in, the opposite occurs in futures and forex. Each contract is an amalgamation of multiple factors that represent the macroeconomic definitive global feelings about that market. Couple that with the correlation and impact of substitute goods and the effects that currency plays on many of these markets, and it becomes quickly apparent that when you “buy gold,” you are voting for and against multiple economies, products, and countries. When you “buy gold,” you are making a subtle or a not-so-subtle no-confidence vote against the U.S. economy, so you are effectively “short stock market (S&P or Dow),” meaning you believe the currency is weak so you are “short the dollar,” which also implies you are “long silver and platinum,” which are precious metals like gold. “Buying gold” also has a correlation to both oil and interest rates, not to mention the euro and the rand. So by “buying gold,” the macroeconomic influences will have a direct impact on how you diversify and whether or not you should. While you may want to invest in noncorrelative markets, the reality is that once you get past two or three different individual commodity markets, there is too much interrelationship to successfully reduce overexposure to the same set of macroeconomic factors. The success of professional traders on the floor has always been specialization. For years, floor traders have succeeded by understanding the buy/sell rhythms of the specific pits that they trade in. When your leverage is 20 to 500 times greater than your initial investment, not specializing exposes you to “overleveraging” your account and not having the ability to weather small downturns in the market. Specialization gives you the ability to calculate and understand your risk at any given time. As a specialist, you are able to become better equipped at the macroeconomic influences of global commodities such as oil, as well as globally interdependent currencies such as the euro or the Japanese yen. Import and export numbers, as well as central bank meanings, take on a life of their own. If there is an overwhelming need to diversify when it comes to the commodities and currency markets, then look to the various commodity indices. The Commodity Research Bureau (CRB) puts out a Continuous Commodity Index (CCI) that tracks 17 different commodity markets. Then there is the Reuters/Jefferies CRB Index, which has tracked 19 different commodity markets since 1957. There are also the Dow Jones Commodity Index (DJ AIG) and the Goldman Sachs Commodity Index (GSCI). While both indices are meant to give a well-rounded view of the markets, they both suffer from the macroeconomic factors discussed earlier. The GSCI has enjoyed much success over the past several years. This success has been largely due to its direct correlation with the oil commodity complex. At one point GSCI had a weighing of 80% in the oil markets and the DJAIG had a weighing of 33%. So while you are trader who may want to be fully diversified, it is difficult to do on a macroeconomic scale, as evidenced by the major companies that have commodity indices yet have one third to four fifths of their assets concentrated in one area.
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exchange-traded funds, Continuous Commodity Index, Portfolio Diversification, ETF, CCI, CRB, DJAIG,
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