Diversification Over Sectors

Many suggest that Diversification Over Sectors is one of the key models for limiting risks when trading in the stock market.

The idea is that you should constitute a portfolio from diverse sectors to increase your chances of growth : when a given sector grows more than others you want to be a player in it, and to decrease chances of loss : if a given sector is going down you don't want to be a major player in it, you want to be a player ALSO in other sectors that are not doing that bad.

But how does DOS actually do in a world that is highly vulnerable to the big unpredictable events ? How would your diversified portfolio do when a Black Swan hits ? Would Diversification Over Sectors bring you more profits ? Would it protect you from major losses ?

We'll look at empirical facts about Diversification Over Sectors. We will look at one famous model of Diversification : Warren Buffet. We will look also at the down side, at losses, they are what matters most when trading : we don't argue that profits are better than losses, but coming back home with your initial investments is better than loosing, am I right ?

DOS and profits

We all know that in good times most of sectors grow side by side, the Dow is greener than before and everyone's happy, in other times some sectors do clearly better than others and they look like "the sector" to invest in, consider the .COM bubble, the lucky times of technology in which this sector may look like paradise.

Not willing to think much about what sectors to focus on, many people argue that Diversification Over Sectors is the answer, they give a very famous example of diversification : Warren Buffet.

Many people think that diversification is one of the key factors of Buffet's success. His companies portfolio is revealed to be "very well diversified", but how is that really helping him make money ?

I remember that I was once watching a TV documentary about Warren Buffet, what caught my attention more than anything else was something said by one of Buffet's senior employees, I regret not remembering his name but I remember him saying that even if Warren Buffet's portfolio is very diversified but the major profits come actually from a limited number of companies.

So even in one of the most cited examples of Diversification Over Sectors, it is not really helping at the diversification of sources of profits.

DOS and losses

Now let's look at the part that matters most : losses.

The best example I could find to prove that DOS fails in the bad times was the most recent crash of 2007. I used Google Finance to get these charts of how different sectors performed in the months that followed the beginning of the crash. Look and judge by yourself :

Basic Materials Sector



Capital Goods Sector



Conglomerates Sector



Consumer/Cyclical Sector



Consumer/Non-Cyclical Sector



Energy Sector



Financial Sector



Healthcare Sector



Services Sector



Transportation Sector



Utilities Sector



(Due to technical difficulties I will add Technology sector later)

When a major unpredictable event happened ALL SECTORS were hit very badly. This empirical proof leaves no doubt that even the portfolios based on Diversification Over Sectors were highly vulnerable to the Black Swans.

Concentration is evil

Simply put Concentration is putting all of your eggs in one basket, I can cite two types of it :

Concentration Of Decision: when the very few make the most important economic decisions on the behalf of everyone else. As we will see this is a disasterous way of ruling anything. We can see this type of Concentration in investment banking where few traders gamble the belongings of many, when loss happens -and it does, the majority will be hurt, not just investors but all those that rely on Banks in one way or another: everybody.

Concentration In Time : this means making many trading decisions in short time, gamblers that play most often are the first ones to start loosing even after they get lucky, they run out of luck very quickly. CIT is one of the ways of exposing oneself to Black Swans, the bad type of them.

In the following paragraphs we will see how concentration can hurt.


This is how communism broke over stupidity

Communism started with books, large books filled with theories on how unfair life is and "how the world should be".

The problems started when the repressed people of Russia has had enough and it was time to take down the owners of land that treated them like slaves, the problem is not the revolution itself, the problem is when they took the extreme decision of building a country system based on theories (yep ! Theories can be that bad!).


The nature of the communist thinking concentrates the process of economic decision making withing the hands of the goverment, in other words the few "planners" working for the communist party had on their shoulders the mission of "planning" to what would or should happen the year(s) to come (I still don't know wich one describes the situation better than the other : "planning to what would happen" implies they CAN PREDICT THE FUTURE which is rediculous, while the other one "planning what should happen" implies they have full control over the future which is even more rediculous than the precedent one !).

No one but the govenment had the right to own production units, only the goverment could decide what should be produced, they though they could predict what will be demanded by the population and produce for them exactly what they need, they though they had full control on what will be sold and bought, I don't need to tell you they were wrong.

It seems that decision makers that concentrate too much when thinking make the most desastrous decisions. There is this french psychologist called Pierre Daco who gives neurological evidence that you should always stay open minded and not focus too much, otherwise you will only norrow your mental abilities.


The collapse of the Soviet Union was -in opinion due mainly to the Concentration Of Decision, COD is highly fragile and it made them very vulnerable to the unknown: Black Swans. The Concentration Of Decision is an example of "How Not To Do Things". The ruling of the former Soviet Union is similar to putting all of your eggs in one basket, or investing all/most of your money in one trade.

On the other hand there is Capitalisme (I still argue with myself whether or not Capitalisme is a system), capitalisme is "letting things be", no particular way of doing things, free market, the Diversification Of Decision distributes the risks, more economic decision makers means more agents to have disasters devided on, it means that in the worst cases companies may vanish but OTHERS WILL SURVIVE. This is -in opinion the main idea on how capitalisme is better.


The ironic twist is when the supreme virus of communism penetrates to the spiritual core of capitalism: Concentration in Wall Street.

Notice how I called Wall Street "spiritual core", if Wall Street becomes anything more than that, let's say "the real core" of capitalisme this means that the whole idea of distributing risks is bypassed and concentration will get eventually to hurt everyone, guess what : that's what happened in 2007.



... and so did Wall Street


For the sake of effeciency the foolish bankers made the process of trading decision making be concentrated in few insitutions that hire few traders that -in the end have similar trading mentality. Just like in the old times of communism few people make the most influent economic decisions on the behalf of everybody else. Capitalism took a very dangerous turn: instead of having many economic agents making many -but less influent decisions we have a bunch of traders gambling the largest sums of money on behalf of everybody else. What is really sad is that even those who were proven to be loosers can still enjoy big bonuses, and even if they get laid off they will be replaced by fresh finance graduates that are just as doll as the old ones, but they are just less experienced with big losses.

The financial system was sitting on a barrel of dynamite that blew up eventually, now it is sitting on another barrel getting more and more filled with explosives, none of us know when it will explode again, but it will.

Communism is similar to finance in the way of how suckers feel and look like genuises. In the former Soviet Union they had statuts built after them; in Wall Street they get big bonuses, sometimes even after they cause a catastrophe. Will people ever learn???

Reality Shows channels : a spot for Black Swans

From the beginning I was amazed by the idea of reality shows, simply because YOU NEVER KNOW what's on, it is not like the old fashion shows that try to show you exactly what they think you want to watch. Old fashion shows tend to get boring and predictable, noticed ? I said predictable and that seems to be a bad property of a TV show, series writers know something about that and it is no secret that they try all the time to keep their shows exciting, interesting and most importantly unpredictable. Seriously won't it be less exciting if you could predict how the show ends ?

The unknown is a very complex subject and approaching it seems to be a shady business for most of people. But whoever started the Reality Shows business deserves a great deal of respect from me.

At some time someone said : "What the heck ? Let's put a group of people together and see how they act in front of cameras, we don't know what could happen but what's the worse that could happen ?". Since the people on reality shows are less likely to commit a crime when the whole world is watching, than putting them together is not so bad after all, the risks of this project are pretty low to me. On the other hand YOU NEVER KNOW what these people are going to do in front cameras, this means you are open to the interesting stuff they might do, it may get really exciting, but the point is YOU NEVER KNOW.

Risks VS Profits
In the example above are mentioned risks and profits of the project, let's illustrate :

Risks : on a reality show you never know what people on it are going to do, but what's the worse that could happen ? Someone build a nuclear bomb under cameras ? Someone commit a murder while the whole world is watching ? Not likely to happen ! Nothing excludes the possibility of such things to happen, but I dare to say it is very unlikely to happen. I just illustrated some extreme risks and not the risk of the show failing to gain popularity as it is a very common thing (I read in some Marketing book that most newly launched products are failures, this means that when a show fails it is not an extreme event).

Profits : on the other hand WE NEVER KNOW how successful the show is going to be which keeps the expectations of profits wide open, why ? Simply because of the nature of the unknown : We never know what is going to happen on a reality show. It is possible (we don't know how probable or improbable it is) the happening of an event that brings most of the world around television to watch. That would be a Black Swan and Black Swans do happen.

Bold decision
I see it as a bold and rare decision from the managers of whatever TV network decided first to launch a reality show, I respect their approach to the uncertain and the unknown.


The Spot

Even bolder than the idea of starting a reality : there is the idea of starting a spot that hosts reality shows. That way you maximize your chances of having the show that would make you very successful, have you ever heard of "Pimp my ride"? A famous reality shows about modifying cars that shows on MTV, guess who introduced me to the other : MTV or "Pimp my ride" ? Actually I wasn't personally a big fan of MTV ( I don't know why !?) but it is that show what broutgh to watch that channel, not only "Pimp my ride" but also other reality shows that I may like or not (I liked some of them by the way). More than my personal experience what matter are the aggregate effect of MTV's policy on the popularity of the network. I will illustrate with another example.

What you think made the other one famous ? Was it YouTube that made people's videos famous ? Or were they the videos of everybody that made YouTube a success ? I can see that it works both ways but I dare to say that YouTube became famous from the videos posted on it. Notice that the creators of YouTube didn't bother to hire show writers and directors and all the costs that come with that : they simply created a Spot for the unpredictable : a Spot for Blog Swans. Just go on YouTube and look for the videos seen by millions of people, isn't amazing how many Black Swans they caught?

I decided to start this blog in the aim of finding practical ways of living in a world in which Black Swans DO HAPPEN, practical ways to deal with them in the fields where decision making has big influence on our future : investing and management.

I chose this topic to be my first article to illustrate in a simple way that we can approach the unknown in ways that limit risks and stay wide open to positive consequences.