How Differences between CONVERGENT and DIVERGENT Strategies Work in Practice?
Constancy and persistence versus inconstancy and opportunism
We’ll demonstrate the principle on a simple probability-based game, such as flipping a coin. Let’s say that if our tip is right, we will take a quick win, if it isn’t, we will double the bet. This is the well-known Martingale System which has been used by many madmen, for example in sports betting. If the madman was smart enough and set limits for profit and the risk he was willing to accept, I see no problem in this approach. The truth is that the longer we apply this approach, the higher the likelihood of an unpredictable series of losses that can “wipe out” our entire capital, even within one trading day.
Convergent strategies work on a similar principle – they increase bets after each loss in the same way. They are also based on the faith that a win will come eventually and the investment will return. The common strategy for dealing with a series of losses is a “dilution of losses” through raising bets. But if an unprecedented series of losses comes, the strategy suddenly becomes – euphemistically said – undercapitalized.
Divergent systems work the opposite way. You don’t base your system on faith and if the market (or coin flips) develops differently than you expected, you don’t raise your bets – on the contrary, you stop placing them immediately. If the system is successful, you multiply your bets. Therefore, divergent strategies work on the principle that when a system finds a certain advantage or a profit opportunity, it exploits it as long as possible. The statistical analysis of both approaches shows that they have different distributions of returns – as can be seen from the above example, convergent systems generate many small profits with occasional fatal losses in the long run. Divergent systems, in principle, work exactly the opposite – they generate many small losses and hope to profit on an extraordinary favorable movement. Contrary to the constancy and persistence, which characterize the buy-and-hold approach, this strategy is based on opportunism and inconstancy. But don’t get discouraged by positive or negative tones – investing is not similar to interpersonal relationships and it shouldn’t be influenced by emotions.
Stable World Versus World of Coincidences and Reversals
When we interconnect these theoretical concepts with the investment practice of long/short equity funds or trend-following systems for trading shares, we can easily identify market conditions under which the systems will deliver the best results. Let’s leave coin flips and have apply the two approaches to an example situation from real market environment: value investing, also called private equity (i.e. investing in a company with a long tradition) is rather a convergent approach. The strategy uses leverage in a more “predictable” investment environment. It is based on fundamental analysis and belief in a long-term success of the company’s core business. The investor considers the market environment as more or less effective and rather stable, the information is known and directly reflected in the market. The market itself is highly competitive.
On the other hand, investing in start-ups and “growth investing” are totally divergent approaches. Less weight is put on fundamental analysis because the correct, “fair” assessment of a company is biased by many unknown factors, i.e. such assessment has to be far more complex. Most of the most successful venture capitalist managers diversify their portfolios by buying many smaller shares in a large number of companies. They count with losses and aim at finding a future giant, such as LinkedIn. Such approach to the risk is ideal for random market environments with unknown conditions and numerous random events with unknown impacts on the portfolio. The same characteristics has the classic trend-following system.
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