Always Diversify?
The myth: more positions always means less risk. The math disagrees. Diversification distributes ignorance more evenly. Here is the Kelly Criterion proof.
Tuesday 21 July 2026 – Available on Spotify, Apple Podcasts, YouTube, Amazon Music
Where the Myth Comes From – The Critical Qualifier Nobody Mentions
Harry Markowitz’s Modern Portfolio Theory proves mathematically that combining assets with imperfectly correlated returns reduces portfolio volatility without reducing expected return. For passive investors who cannot identify which assets will outperform, this framework is correct and valuable.
The critical qualifier Markowitz embedded – and that is routinely ignored – is this: MPT assumes you have no information advantage about individual assets. If you do have a tested, documented edge in specific setups, spreading capital across many positions that do not share that edge does not reduce risk. It dilutes the edge that makes active management worth doing at all.
- Modern Portfolio Theory – what it actually assumes and who it applies to
- The Kelly Criterion formula – the mathematical framework for sizing when you have positive edge
- Why under-betting positive expectancy reduces long-term compounding (with numbers)
- The mathematical proof that diversification dilutes active edge
- When diversification is correct, and the decision framework for active traders
The Kelly Criterion – The Math of Optimal Sizing
John L. Kelly Jr. at Bell Labs in 1956 solved the problem of optimal bet sizing when you have a positive-expectancy edge. The formula:
Kelly % = (Win Rate x Avg Win/Loss Ratio minus Loss Rate) divided by Avg Win/Loss Ratio
The critical implication: betting less than the Kelly-optimal fraction reduces long-term compounded growth rate. Diversifying capital into positions where your edge does not apply is precisely this – you are deploying capital at zero or negative expected value instead of at your positive edge. The long-run cost compounds.
The Dilution Proof – What Diversification Costs an Active Trader
Consider a trader with a documented, tested edge in FX breakout trading. System profile: 45% win rate, 2.5:1 R:R, positive expectancy confirmed over 300 trades. Half Kelly suggests 13.5% of capital per trade.
That trader decides to diversify by also trading equities, crypto, and commodities – markets where they have no tested system and no historical expectancy data. Result: their FX edge is deployed at a fraction of its optimal Kelly fraction. The remaining capital is in markets where expected value per trade is unknown and likely near zero or negative. Portfolio expectancy drops significantly. Transaction costs in the underedged markets create drag. This is not risk management. It is edge dilution.
When Diversification Is the Correct Strategy
Three Principles That Replace the Myth
“Diversification is protection against ignorance. It makes very little sense for those who know what they are doing.”
– Warren Buffett
“The Kelly formula tells you how much to bet. If you do not use it, you are leaving money on the table. If you exceed it, you will go broke.”
– Ed Thorp, Beat the Dealer
Episode Timestamps
Continue Learning
- Position Sizing: The Complete Guide
- Risk of Ruin Mathematics
- Money Myths EP01: Expectancy – The Foundation
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