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There has been and still is the idea that ‘diversification’ is a risk management tool, and to a certain extent, it is. However, diversification linked to leverage, changes that assumption into something very different.

Diversification, of uncorrelated markets, or securities, say Nike common stock and London mortgage securities, would seem prima facie, unrelated or uncorrelated. However a trader who holds these same securities as another trader, now correlates those securities as any trader who holds them becomes linked to every other trader who holds those securities.

When leverage forces you to sell, you sell what you can, not what you should.

Now when selling what you can, that may very well be Nike, and now you have a rush for the exits in Nike, of every trader on margin, who holds London mortgages [or whatever]. In times of stress, all markets and securities are correlated by the traders who hold them. Diversification is a chimera.

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