Behavior finance, risk and diversification

Diversification is an old story. Anyone wants to know what is diversification should read a textbook but not my blog.

Risk is a bit different. Many people define risk differently. I want to make things simple and straight forward. Risk should define as: given a limited period of time, the chance that you cannot recover to breakeven. This can range from a heteroscedastic random variable to a more normal random variable. Sorry I can't really tell you a correct answer.


Behavior finance studies the rationale (and irrationale) of how people make financial decisions. A very practical idea.

I want to give an idea combining all 3.

I trade stocks more than buy-and-hold. So if a stock drops by certain %, I rather close my position and save the money for the next opportunity (I have put aside some other savings for investment as well). To me, the biggest risk to me (that will make me sleep worse) is, the gap risk.

A stock may gap up or down due to news. The problem is, if I'm long and it gaps down by so much that surpass my cut-loss point, I feel so hesitated. You know, if it gradually drops to the cut-loss point I'm okay, but if it gaps down and bypass the cut-loss point I will feel so bad because I don't have the chance to cut loss at the point I set. But if I don't cut it I may lose more. If you had the same experience I think you will understand.

Therefore, here you come diversification. Since I don't know which stock may gap at any time, bet on more stocks at least will reduce the pain if any one stock gaps. So you see, diversification is very powerful, it helps to reduce your worrisome and make you sleep well.