Diversification Approaches: Stock Portfolios vs. Options Strategies in the Long Term

Financial markets come with inherited risks, which is why it’s critically important for every trader and investor to learn how to properly manage risks. There are various risk management strategies for traders to use, among which, one of the most widely used is diversification.

There are investors and experienced professionals on both sides of the argument. Some believe that putting your eggs into one basket is a good idea, while others think that it’s stupid and people should find many other baskets to limit risks. The main argument of one basket believer is that it's much easier to conduct research and find a limited number of companies to invest in, rather than carelessly pick multiple companies from different industries.

Diversification is a widely used investment strategy that involves investing in various instruments and spreading risks instead of concentrating on single instruments. The main idea behind Diversification is to get exposure to different markets that have no correlation with one another, so that if one asset’s price dips, the overall balance remains protected.

Traders and investors use stock portfolios and option trading strategies to diversify their risks in the financial markets. Let’s delve into more details of each method.

Diversification with Stock Portfolios

Diversification using stock portfolios involves creating a collection of stocks from different sectors, industries, and geographies regions. The main goal of Diversification is to build a mix of stocks portfolio that don’t all go up or down together. While it's true that it's difficult to find assets that have zero correlation with each other, the smaller the correlation, the better.

When picking stocks for a diverse portfolio, there are a couple of factors that need to be taken into account. In addition to choosing assets from different industries and low correlation, traders need to select a portion of each stock into a portfolio. In this process, company size matters. Traders should consider companies with different capitalisations and price volatility. Some stocks are highly volatile, while others move steadily. In addition, it’s important to think long term before investing in a company. Shares of young companies can go up dramatically, on the other hand, new companies are also risky due to their lack of experience.

Market conditions change, some stocks gain value, while others lose. As a result, the ratios keep changing. Traders need to keep adjusting their portfolios accordingly.

Diversification with Options Strategies

Diversification using Options involves investing in various options contracts. An Option contract in financial markets is a derivative that gives the holder of the contract the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (which is known as a strike price) within a specified timeframe. There can be various asset classes as underlying assets such as: stocks, indices, commodities, currencies, cryptos, and other financial instruments.

Options contracts are grouped in two major categories, such as Call Options, and Put Options.

Call Options: investors and market speculators typically purchase Call Options when they believe that the price of an underlying asset will increase. When a trader buys a call option, it gives him a right to buy the underlying trading asset at the strike price before or at the expiration date.
Put Options: investors and speculators purchase Put Options when they are expecting the price of an underlying asset to fall. A Put Option gives its buyer the right to sell the underlying asset at the strike price before or at the expiration date.

Drawbacks of diversification

There are two approaches to diversification. Some believe that it's essential for every investor to spread risks, while the critics believe that those who diversify their portfolios do not know how to find worthy stocks to invest in long term. Putting your eggs in multiple baskets comes with many risks that need to be taken seriously. Let’s discuss them in more detail:

Over-diversification: when investments are spread in too many companies, it becomes more difficult for investors to beat the market.
Missed opportunities: diversification means that investments are spread among different sectors and companies, and when particular stocks become successful, their impact on overall investment balance is not significant.
More research needed: It is always challenging to find a company or option contract worth investing in. When traders try to diversify, the quality of investments drop. Investors need to check many details. In addition, it’s important to remain informed about ongoing developments to avoid bad surprises. When you have many baskets to keep an eye on, guarding individual ones becomes highly challenging.
Investing using small capital: Investing in a diverse portfolio can be profitable, however, the profit margins cannot be huge, especially when starting with a small investment balance. Diversification is a passive form of participating in the financial markets and it's a widely accepted truth that passive investing takes a lot of time to bear fruit.
Limited learning opportunity: when traders put their money in different baskets, such as stock indexes, and different individual stocks, they tend to also diversify their attention and lose focus on single companies. Diversified portfolios offer less learning experience for traders.
Diversification is for old people: Diversification is less risky, and in financial markets risks and rewards are correlated. Higher the risks, higher the potential for rewards. In general, young people are looking for opportunities to make a lot of money and can afford to lose their savings because they have all the years and energy to be able to save for retirement again.

Key Takeaways

To sum it all up, building diversified portfolios help traders and investors manage their risks. Two popular investment vehicles for diversification include investing in stock portfolios and Options contracts. When investing in stock portfolios, traders try to pick uncorrelated companies from various industries and sectors. Diversification using options contracts is easier as traders can find options from different asset classes. While Diversification helps traders reduce their market exposure to one particular asset and help manage risks, they bring their own challenges with them, such as over-Diversification, missed opportunities, limited learning opportunity, and more time needed to conduct market research. In addition, Diversification approaches require larger capital than focusing on single company shares.