How to Diversify Your Trading Portfolio

Although risk is an inherent part of participating in the financial markets, expert traders know that these risks can be effectively managed. If you’re a new trader, one of the first things you need to learn is risk management. While there are several risk management measures that can be added to your trading strategies, such as using stop losses, one of the most popular methods to effectively manage risk is diversification. This means spreading your eggs out into multiple baskets so that if you trip and drop a couple of baskets, all eggs aren’t lost. Consider the mess if you where to put them all in one basket and then trip!

What is Diversification?

A good way to diversify your portfolio is by trading different assets that are not correlated with one another. But what does that mean?

Let’s suppose that you are trading gold, along with the shares of a gold mining company. Both these securities are likely to move together although they are very different types of assets – one is a commodity and the other is a stock. But both will be affected by changes in the gold price. So, when the price of gold drops, it will impact your commodities trading position, while the stock might decline due to falling gold prices. So, while you might have thought you were diversifying your trades, it wasn’t really a true diversification since both assets are correlated.

So, the real trick to diversification is trading securities that move independently of each other, so that price movements in one security neither affect nor mimic that of the other securities. For example, suppose you’re trading gold and oil. Now, you might think that both being commodities, you haven’t diversified across asset classes. But the reality is that historically, gold and oil prices share an average correlation of zero . This means that the price of gold usually does not affect or reflect the price of oil, which then effectively diversifies your trading portfolio.

So, the main aim here is to include a diverse group of securities in your trading portfolio so that the underperformance of one or more assets can be mitigated, if not compensated for by the other assets.

Why is it Important to Diversify?

There are several benefits of diversification:

Reduces the Impact of Market Volatility

An experienced day trader will tell you that the markets can turn highly volatile without notice, especially in the short term. While you don’t have any control over this volatility, to be a successful trader, you need to anticipate and plan for this volatility. Diversifying your trades is one of the ways in which you can do just that.

A diversified portfolio means that your trading capital is not dependent on the movement of one or two securities. If you trade multiple assets, it increases your chances of making an overall profit even if some of your trades go south.

Takes Advantage of Growth

When you diversify your trades, you increase your options.

Suppose you believe that the prices of commodities, such as energy and precious metals, are likely to rise in the near term. A beginner trader might be tempted to place a single large bet on a single precious metal, like gold. However, an expert trader is more likely to place a large number of small bets across multiple commodities, including precious metals, energy and agricultural products. This not only spreads their risk, but also enhances the potential for positive returns.

Helps Keep Capital Intact

Some new traders might be tempted to invest all their trading capital on one or two “sure-shot” trades. They could believe that the potential returns justify the associated risk. However, if you want a long-term career in trading, you need to keep your trading capital safe. This means that you need to be very careful how much you invest in each trade and how much you might lose if the market goes in an unfavourable direction.

By diversifying your portfolio, you can ensure that your trading capital is not dependent on the movement of one or two securities. It is also more likely that losses in some trades might be balanced out by other trades, keeping your overall capital safer for future trading.

Reduces the Stress Associated with Each Trade  

Stress can impact your performance in any line of work. Trading is no different. Emotions impact our decision-making abilities, leading us to make irrational choices sometimes. For example, if we are scared that the market could reverse, we might close our position even before it has a chance to earn a profit. On the other hand, if we feel overconfident after a string of wins, we might overtrade, leading to losses. This is why expert traders recommend that we keep emotions out of our trading decisions.

Of course, it can be stressful because trading involves real money. But when you know that you have taken all possible measures to limit risks, like diversifying your portfolio, it can help relieve a lot of that stress. You then gain confidence that if even a couple of trades don’t work out, the others might.

How to Diversify?

Here are ten ways in which you can diversify your trading portfolio.

1.      Spread Your Money

As mentioned earlier, it is prudent not to invest all your trading capital in only one or two assets. Trading is a numbers game, and you need to make the numbers work in your favour. So, rather than making two large trades, consider making a large number of small trades. This spreads your investment out over multiple assets and positions, diversifying your portfolio and increasing your chances of earning a profit, even if a few trades don’t pan out the way you hoped.

2.      Diversify by Asset Class, Sector and Geography

Spreading your money is only part of the story. The next part is knowing how to spread your money. How do you ensure that your trades are not all correlated and which securities to pick when diversifying?

The answer is to diversify according to asset class (such as commodities, shares, forex), sector (such as finance, real estate, technology) and geography (such as America, Japan and Europe).

For example, you can trade the US dollar/Japanese yen forex pair, along with trading the stocks of blue-chip European companies and crude oil. As you can see, with such trades, whether a particular asset, sector or region becomes volatile, you still have other positions that could protect your trading capital.

The beauty of this type of diversification is that it also saves you from being vulnerable to any single market-moving event. If the Japanese economy is slowing down, it may not affect your trade in crude oil.

3.      Hedge Your Bets

Hedging means reducing the risk associated with one trade by making another trade in the opposite direction. Popular trading platforms like MT5 support hedging. For example, you may go long on a gold CFD as well as on the US dollar. This is because the two assets are inversely correlated, meaning that when the US dollar weakens against other currencies, gold price tends to rise.

Hedging your bets allows you to play both sides. If a trend seems to be going in a favourable direction, you can quickly capitalise on it by removing your hedge. Similarly, if a trade seems to be going south, you can mitigate losses by hedging.

Remember that hedging may not protect you from all negative impacts of an event, but it can greatly reduce the impact.

4.      Hold Both Long and Short Trades

The biggest advantage of trading CFDs is that you can hold both long and short positions. A long position is usually taken when you expect the value of a security to rise, while you take a short position when you expect the value of a security to decline.

A good way to diversify your trades is by holding both long and short positions. For instance, you only have short trades and the market enters a bull phase, which means that the value of all securities is rising. In this example, you might make losses on all these positions. You can protect yourself against such a scenario by entering both long and short trades.

5.      Consider the Volatility

Not every asset class is created equal. Some asset classes are inherently more volatile than others. So, when you’re looking to diversify your trading portfolio, consider diversifying according to the level of volatility as well. This is because higher volatility often means higher risk. You can balance more volatile securities with less volatile ones. For example, oil tends to be more volatile than precious metals. So, despite both being commodities, you could use them to balance out volatility.

6.      Understand What Moves Different Asset Classes

Price movements in the financial markets are not random. Every asset has its own set of factors that determines how the asset will behave. For example, the price of gold usually goes up during times of economic uncertainty and turmoil. This is because gold is considered to be a “safe haven” asset and people invest in gold when other investment options seem too risky.

It is a good idea to understand the factors that affect the assets you’re trading. This can help you make informed trading and diversification decisions.

For example, you can trade securities that are dependent on the price of gold (such as shares of gold mining companies) and then diversify by trading securities that have no relation to the price of gold (such as companies in the energy sector).

7.      Diversify Across Global and Domestic Securities

Another good way to diversify is to expand your horizons. Choose a broker who offers you exposure to both domestic and global asset classes. Both forex and CFD trading can help you gain exposure to international and local asset classes.

The prices of several assets are dependent on global factors. For example, the price of oil is dependent on geopolitics and economic activity or global demand. In contrast, some securities operate independently of global events. For example, the share price of a domestic company may only be affected by national events. 

When you mix and match such securities, check that their price movements aren’t correlated.

8.      Note Your Financial Biases

You might have a preference for some assets, compared to others. Most traders do. For instance, some traders prefer to trade forex while others prefer to trade stocks.

As a beginner trader, this is a great time for you to identify your biases and make them work for you. For example, if you love to trade gold, then you can identify certain securities that are inversely correlated to gold and some that are agnostic to gold. In this way, you have a ready list of securities that you can use to diversify your trades.

9.      Consider the Spread and Commission

The spread is a fee charged by the broker to execute your trades. The spread is the difference between the bid and ask price of an asset and depends on a variety of factors, such as the timing of the trade, the asset being traded and the liquidity in the market. So, the spread can vary depending on the asset and the market conditions at the time at which you trade.

Some trades can be more expensive to execute than others. If you find that you have made a lot of expensive trades, you could balance it out by making a few cost-effective trades, so that the overall cost of your trading is reduced.

10.  Don’t Overdiversify

Yes, it is possible to over-diversify your trading portfolio.

Sometimes you can add trades that do not impact your potential returns or reduce risk. Such trades are usually correlated with each other. For example, if you go long on two different American technology companies, then this doesn’t serve the purpose even though you’re adding more trades to the mix.

This is why it is important to note the diversification factor of each trade that you make. If two trades seem too similar, then there may be no point in entering both.

Another point to keep in mind is that the more asset classes and trades you have open at any one time, the more markets you have to understand and stay on top of.

Wrapping Up 

Diversification is an effective way to reduce the risk profile of your trading portfolio. It also allows you to protect your trading capital, as well as increase exposure to multiple types of securities, which in turn could raise your potential gains. As with all trading, never undertake more than you can handle at any one time.

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