The key to successful trading is finding the best methods to reduce your risks in unfavorable markets. This not only preserves your wealth but also makes you disciplined and ready to take advantage of the next profitable run.
Diversification is a risk management technique that works in several different ways, but at its most basic level, it involves combining several different asset classes in a single portfolio.
What Is Diversification in Trading?
Diversification involves distributing assets across various classes, industries, and geographic areas. It is based on the idea that when you hold a flexible portfolio, the weak performance of any single investment can potentially be balanced out by the stronger performance of another to yield an overall satisfactory portfolio return.
Therefore, diversification seeks to include assets that don’t move in sync with each other.
How Do You Calculate Portfolio Diversification?
Correlation is a measure of how the returns of various assets in a portfolio relate to one another. It helps investors judge how well-diversified their portfolio is.
It is expressed as a number ranging between +1 and -1. A positive correlation tells us that the two assets move together, on average, over whatever time period we’re looking at. A high positive correlation between two assets means that they generally move in tandem, which is not good for investors hoping to achieve some sort of diversification benefit.
For example, an investor who holds gold and silver can expect both assets to gain and lose value simultaneously. Similarly, copper and oil prices have a positive relationship since both commodities produce energy and manufacture goods.
Conversely, a low or negative correlation means that the two assets do not move together and, indeed, should be the type of assets investors add to their portfolios. Stocks and bonds are popular examples of assets with negative correlation — traditional portfolios are known to include both.
Thankfully, platforms like the TradingView app have a built-in Correlation Coefficient (CC) to help traders. To find the correlation between two assets, go to Indicators & Strategies and search for Correlation Coefficient. Click on it, and a box will appear where you can enter the asset you want to compare. Press Enter, and the chart will instantly calculate the correlation.
Benefits of Diversification
The consensus among investment professionals is that diversification is an effective technique for reducing risk in an investment portfolio and achieving long-term financial goals. Here are some of the advantages of a diversified portfolio.
Protects Against Huge Losses
This is especially important in volatile markets and for investors who need to preserve wealth. A key rule in risk management is to evaluate the probability of each trade being successful. You won’t always profit from every trade, so it’s essential to protect your existing capital and ensure you have a solid strategy with a positive risk-to-reward ratio. If you are also living on portfolio returns and need to protect your capital from large losses, it is crucial to consider risk over returns.
Reduces Overall Risk
Diversification helps improve a portfolio’s risk-adjusted returns because it allows investors to reap greater rewards without proportionally increasing the amount of risk they take on. Risk-adjusted returns are a way of measuring efficiency in investing, and for those who would prefer to trade riskier assets, it’s a way of making sure they don’t incur significant losses. For traders and investors who like to play it safe, it ensures they make substantial gains that beat inflation.
While riskier investments may offer higher potential returns, risk-adjusted returns show how effectively an investor’s capital is being utilized.
The Sharpe ratio is one of the most used variables for this. It calculates the profit of an investor compared to the risk they’ve taken.
For example, consider two portfolios (assuming a risk-free rate of 4%):
Sharpe Ratio= Rp−Rf/σp
Where:
Rp = Expected Portfolio Return
Rf = Risk-free Rate
Sigma(p) = Standard Deviation of the Portfolio’s Excess Return
Portfolio A: 100% invested in a single tech stock
Expected return: 12%
Volatility (risk): 25%
Sharpe ratio = (12% – 4%) ÷ 25% = 0.32
Portfolio B: Split between that same tech stock (50%) and a broad market index fund (50%)
Expected return: 11%
Volatility (risk): 20%
Sharpe ratio = (11% – 4%) ÷ 20% = 0.35
While Portfolio A has a higher potential return, Portfolio B achieves a better Sharpe ratio due to diversification between assets that don’t move in perfect correlation. The higher Sharpe ratio indicates Portfolio B generates more excess return per unit of risk taken.
Creates Better Opportunities
Diversification also opens up new opportunities for growth. For example, if you decide to invest in a streaming service to diversify away from forex trading, you might benefit from unexpected gains if the streaming company announces a major content partnership. If you don’t move to other industries or currencies, you will miss out on positive developments outside your primary sector.
Diversification encourages you to explore new industries and compare assets. However, there are some disadvantages.
Downsides of Diversification
Although experts always praise diversification, there are some downsides to this strategy. A portfolio with many different pieces can be bulky and difficult to manage. Yes, there are modern “portfolio trackers” that can help report and summarize the holdings, but even the tax information needs to be maintained separately for each kind of asset. When you have a lot of pieces to track in a portfolio, that alone can make the strategy a bit tiring.
Also, traders will be forced to settle for lesser profits if they don’t have the capital to make concentrated bets on certain parts of the market they feel strongly about. Warren Buffett famously challenged this wisdom, stating that “diversification — as practiced generally — makes very little sense for anyone that knows what they’re doing…it is a protection against ignorance.” This is evident in Buffett’s own investment strategy, where Berkshire Hathaway concentrates 75% of its investments in just five companies, with Apple alone comprising 44% of the portfolio.
For skilled traders who deeply understand specific sectors or companies, diversification can force them to settle for lesser profits instead of maximizing returns in areas they know best. Moreover, managing a highly diversified portfolio often leads to higher transaction costs due to the increased number of trades needed for rebalancing and portfolio management.
Using Diversification To Reduce Risk in a Forex Portfolio
Different currency pairs often react differently to economic events. Diversifying across various currency pairs, regions, and economies can help forex traders reduce the risk associated with individual currency movements. A typical diversification approach could include a balanced mix of currencies from stable economies, high-growth regions, and commodities-driven countries to spread out risk. Similarly, swing trading offers a dynamic way to capitalize on short-term market trends, so integrating insights on “how does swing trading work” into a diversified portfolio strategy can significantly reduce risk and enhance your overall trading performance.
Here are four common diversification strategies to consider in forex trading:
1. Across Currency Types
This involves holding a mix of major, minor, and exotic currency pairs. Major pairs (like EUR/USD, USD/JPY) are typically more stable and liquid, while minor and exotic pairs can offer higher volatility and potential returns.
2. Geographic Diversification
Economic conditions vary across regions, with factors like interest rates, inflation, and trade balances influencing currency values differently. For example, while Federal Reserve policy changes may affect the U.S. dollar (USD), the euro (EUR) could react to European Central Bank decisions.
3. Diversification by Economic Sensitivity
Some currencies are more sensitive to global economic growth, while others are safer in downturns. Commodity-based currencies like AUD and CAD often benefit from strong global demand for resources, while currencies like JPY and CHF may provide stability during market turmoil.
4. Across Currency Correlations
Certain currency pairs may show positive or negative correlations, meaning they move similarly or oppositely under certain conditions. For example, AUD and NZD often have a positive correlation due to similar economic influences, while USD and JPY may show a negative correlation during risk-on/risk-off scenarios.
Does Diversification Reduce Trading Risk?
Diversification is a key method in financial planning and investment management. The idea is that by distributing investments across different assets, you reduce the overall risk of your portfolio. Rather than putting all your money into a single asset, diversifying helps protect against significant losses. With the convenience of online investing, it’s now easier than ever to diversify across various asset classes and strategies.
