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This post was spawned by a discussion I kicked off in the YONG board around the construction of portfolios ... in particular the concept of baskets and their uses in this service.

As an intro: Whilst I generally acknowledge the usefulness of diversification, I feel that there comes a point where it becomes in effect meaningless. The following is from an email discussion:

Re the basket approach - I made a post reply to that earlier today. My main concern here is that you're effectively trying to combine something very high risk with something that almost equivalent to US market risk (e.g. KO) in an attempt to diversify and reduce risk. That's fine as far as it goes but you're also diversifying out return potential. So, in the end, even with potential of 100%+ returns, you have a choice: you either have a meaningful position of the high-risk stock as part of the basket or you may as well not have it because even returns of 100% or more don't move the needle in terms of the basket return enough.

It's not that the concept is wrong, it just that when you hit extremes that it doesn't quite work so well for us humans ... it's a bit like the frequentist fallacy in statistics ... unfortunately, we can't repeat the 'experiment' thousands of time and thus simply thinking in terms of expectations isn't the most useful decision support tool.

In this case (YONG), either the stock pays of big, or it craters, or it does nothing (ignore this one given uncertainty). So with a likelihood of potentially large losses (e.g. fraud) and a correspondingly low weighting in the basket your overall return benefits very little from extraordinary returns, should the long thesis be right. Another way to look at is that for cases where the extremes are fairly likely, you don't really benefit from diversification as that is an 'on average' concept, whilst you care for the one binary outcome only. Reverting back to frequentist thinking one could say that the expected payoff is too small to be worth the bother.

Therefore, it seems to me that it would be better to treat these types of stocks completely differently with respect to the advice given by the service - pull them when there is (necessarily subjective) signs of trouble and only re-recommend once that has been cleared off. (It doesn't help labelling them 'ultra high risk' and reducing their weight in a portfolio as such, see above argument above.)

Note that this commentary pertains to only a specific class of stock: Highly speculative EM with a history of fraud and manipulation, in particular, China stocks - not the likes of ITRN, etc.

What do other members think?

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