Trading a specific asset, be it a Forex pair, stock, or precious metal is always dangerous and associated with high risks. On the one hand, you might find yourself in a favorable market trend, which yields significant profits; on the other hand, however, the same trade may go against you and inflict serious damage to your account.
The risk of losing money is always a possibility, and no matter how great you are at managing those risks, you’ll never be able to reduce them down to zero. But that doesn’t mean to stop trying. There are lots of ingenious ways to make your trades less risky and more stable on the market, be it risk/reward analysis, stop-loss/take-profit limits, or portfolio diversification.
This last one, portfolio diversification, is pretty popular among professional traders. It basically means that you limit your exposure to the rapidly-changing market and make investments in multiple asset classes. This way, if one asset is undergoing rapid price fluctuations, the portfolio will still maintain stability because the share of a volatile asset will be insignificant.
In the following guide, we’ll talk about how you can successfully diversify your portfolio with these three simple steps:
Buy multiple different asset classes
This first step is the most obvious, as well as the most important one: a diversified portfolio should have many unrelated assets, which is why going for different asset classes is the best idea here.
The importance of non-correlated assets can hardly be overestimated. Let’s take an example of Forex: Some of the most reliable Forex brokers usually offer ways to diversify your portfolio and make it less susceptible to market fluctuations. And while you should definitely include Forex pairs in your investment portfolio, you should nevertheless be careful which ones to choose.
If you buy, say, the EUR/USD currency pair, buying another currency that has either euro or dollar as one pair won’t be considered as diversification. That’s because the two assets in your portfolio will be associated with each other and if something happens to one, the second will also experience a change, sometimes minor and sometimes major. Yet if you buy non-correlated pairs, a significant price change of one pair won’t affect the other.
But a safer approach in this sense would be to invest in different asset classes so that they’re further apart from one another. And the safest asset classes for this job are ETFs & mutual funds, indices, and/or index funds. These securities already include lots of individual assets and are diversified on their own, so you can make full use of their advantages.
Choose assets that have different return characteristics
This next tip is associated with the investment within the same class. For instance, if you’re buying stocks and want to diversify your portfolio, you shouldn’t jump on one specific stock or a number of stocks that have the same return characteristics. If you were to invest in such assets, the portfolio would still be under the risk or less profitable, based on the rate of return of your asset.
What could be a better idea is to pick stocks from different sectors and companies. Plus, the stocks should originate from companies of different performance. You can buy both high-yielding stocks that promise large profits, as well as low-yielding stocks that increase the stability of your portfolio. For bonds, characteristics such as credit quality or contract duration can help you invest in far-apart instruments.
Don’t treat diversification as a one-time deal
One of the biggest mistakes investors make is they think diversification is a one-time job that they do properly and then never think about again. What’s wrong with that assumption is that it implies the market is static and individual assets don’t change their characteristics.
When you buy non-related assets for your diversified portfolio, you should regularly check its stability and if needs be, make drastic changes accordingly. And it’s not only about the changes in the market that could prompt you to make adjustments to your portfolio; during your career as an investor, you’re going to have varying goals and strategies that will shape the way you invest in assets. Even the slight change in those goals might require you to alter the diversification level of your portfolio and include other assets while removing the existing ones.
A good strategy here would be to rebalance your portfolio at least twice a year. And if you don’t want to do that manually, there are many automated optimization tools that do that for you.