Diversification

noun

1. the action of diversifying something or the fact of becoming more diverse.
2.  a trading strategy that reduces risk.

Diversification is a risk management strategy that contains a wide range of assets within a portfolio. The main reason for having such a portfolio is limiting exposure to one sector or asset that might have a risk. In the financial world, risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.

In other words, risk management occurs when an investor or trader analyzes and attempts to determine the potential for losses in an investment..

The rationale behind this diversification is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

Portfolios have the option to be different in a couple of ways. Not only when diversifying assets, but also when it comes to trading in foreign markets as well as domestic markets. The idea behind this is when a negative event happens in one country’s economy, the trader's portfolio won’t be affected as a whole.  

Diversification by Asset Class

Investors and traders often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Classes usually include:

• Stocks - shares or equity in a publicly traded companies
• Bonds - government and corporate fixed-income debt instruments
• Real estate - land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
• Exchange-traded funds (ETFs) - a marketable basket of securities that follow an index, commodity, or sector
• Commodities - basic goods necessary for the production of other products or services
• Cash and short-term cash-equivalents (CCE) - Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments.

How to understand diversification?

Let’s visualize that your portfolio contains only pharmaceutical stocks. The share prices of these companies are likely to drop when uncertain events happen or when they are affected by bad news of any kind.

If we imagine that a big company somewhere in the world came out with a new vaccine against some new virus and if furthermore was proven that the vaccine doesn’t work in patients, the whole industry will be affected. The stock’s price will drop and the company might experience an enormous loss, also, it will trigger major trust issues among the community.

But this loss won’t happen to the company only, investors, traders and shareholders will lose big portions of their investments and their portfolio will experience a noticeable drop in value.

However, if you have a portfolio of half pharmaceutical stocks and half tech stocks, the good performance of the tech stocks, followed by positive news or good quarter reports works on smoothing out the unsystematic risk events in the portfolio, so the positive performance of some investments (in this case the tech stocks) neutralizes the negative performance of others (the pharmaceutical stocks).

Diversification divided in aspects

1. Diversifying by sectors and unalike industries

The example given before is certainly a clear one when it comes to trading stocks or assets of different industries. You could diversify even further between industries because of the risks associated with these companies.

2. Diversifying between companies

Risk doesn't necessarily have to belong to a specific industry. It can be connected to one company only.  
Imagine a company with an extraordinary leader such as Elon Musk. If that leader decides to leave the company or passes away, the company will be most likely negatively impacted. Risk specific to a company can occur in regard to legislation, acts of nature, or consumer preference. Traders should consider diversifying between companies too and not putting their funds in one company only.

3. Diversifying across asset classes

More modern portfolio theory suggests pulling in alternative assets, an emerging asset class that goes beyond investing in stocks and bonds. With the rise of digital technology and accessibility, investors can now put money into real estate, cryptocurrency, commodities, precious metals, and other assets easily. Again, each of these classes have different levers that dictate what makes them successful.

4. Diversifying between borders

Political, geopolitical, and international risks have worldwide impacts, especially regarding the policies of larger nations. However, different countries operating with different monetary policy will provide different opportunities and risk for traders.

5. Diversifying in terms of time frames

When considering investments, traders should think about the time frame in which they operate. For instance, a long-term bond often has a higher rate of return due to higher inherent risk, while a short-term investment is more liquid and yields less. A medical company might take several years to work through a single operating cycle, while your favorite grocery store might have thousands of transactions everyday. Real estate holdings may be locked into long-term lease agreements. In general, assets with longer timeframes carry more risk but often higher returns to compensate for that risk.

This is why traders love portfolio diversification

There is considerable evidence that shows diversification as trading a strategy to manage risk, works. The main reasons why traders tend to love diversification are as follows:

1. Portfolio diversification helps offset exposure in any single position, and helps investors protect themselves against wide swings in key sectors.
2. Typically, traders diversify by trading both equities and bonds. But in times of market volatility, when investment is made across different asset classes and sectors, the overall impact of market volatility comes down.
3. Traders spend less time monitoring the portfolio, in short terms diversified portfolio is more stable because not all investments will perform badly at the same time.
4. Not every trader is ready to enter the trading session with a huge risk, most traders will take a step further and choose an option that has the lowest risk possible, so in addition to that, traders who are on the verge of retirement or have just started investing, prefer stability in their portfolio so they choose diversification to ensure the protection of their savings. Diversification allows investors to achieve their investment plans while maintaining the investment risk at a minimum.
5. Diversification allows traders to shuffle their investments and take advantage of the market movement. It lets investors spread their investment across different asset classes and increase annual returns.
6. Last, but not least, diversifying can make trading more entertaining, fun and interesting. Diversifying means doing research for new industries, comparing companies against each other, and overall it allows learning new things.

Downsides of diversification

1. Maintaining the portfolio - when it comes to investing and trading with different financial assets, can be overwhelming or difficult to keep constant track of the price movements.
2. Costs - taking care of a broad portfolio could be somewhat expensive. Not all assets cost the same and it might be hard to divide a big portion of your money to invest into a big range of industries, stocks, commodities, cryptocurrencies, etc.
3. Diversification doesn’t prevent losses - even the best analysis doesn’t guarantee a profit, but it can prevent fraud and a portfolio full of bad information.
4. It is not as simple as it seems - individuals with limited investment experience and financial background may feel intimidated by the idea of diversifying their portfolio.

Although, by choosing the right broker, you are given a mentor that will guide you on your trading journey, the menthor will help you learn new information, explain how to read charts and give you the latest info daily based on the assets you choose for your portfolio.

What happens if you use different trading styles?

By potentially using not only one but two or three different trading approaches requires additional skills and training, but this kind of diversification can help to reduce the risks and expand the profits over time.

The trading styles you might consider are:

• Scalping – usually many short-term trades, entered and exited in one day, aiming to achieve profits by catching multiple small wins.
• Day trading – often refers to just one or very few trades, entered and exited in one day, aiming to achieve profits by finding the best buying and selling spot of a financial instrument.
• Swing trading – it’s just one trade, entered and held over several days or weeks, aiming at larger price targets.

Conclusion

Life teaches us that it’s never a good idea to “put all your eggs in one basket”. The same saying refers to trading, traders, investing and investors. For many traders their money should ideally be spread across several asset classes, industry sectors and geographic regions, even economies.

Traders can build a portfolio that includes stocks, currency pairs, indices and commodities. 

They diversify because it helps to stabilize a portfolio’s return, for example the more stocks you own the more likely you are to own a stock that ends up doubling or tripling in price and lowering the risk.

Diversification has its own advantages and disadvantages but by having a right broker by your side your diverse portfolio might be more successful than the average trader.

To start your trading journey with Limit Prime click here.

Sources Consulted:

1. CME groups. The Importance of Diversification https://www.investopedia.com/investing/importance-diversification/
2. T. Segal. Diversification https://www.investopedia.com/terms/d/diversification.asp
3. W. Kenton. Risk Management in Finance https://www.investopedia.com/terms/r/riskmanagement.asp
4. M. Brookshire. How Do I Diversify A Portfolio https://content.stocktrak.com/how-do-i-diversify-a-portfolio