Diversification in trading helps balance the risk and reward ratio for an investor. Spreading the investment into more than one type of security expands your (the investor’s) market exposure and increases your probability of profiting from both rising and falling markets. If you diversify your portfolio, there is a higher chance that even if one security drops, the others increase in price, saving you from hefty losses.
In this article, we discuss how you can build a diversified portfolio successfully:
What is portfolio diversification?
Portfolio diversification refers to the practice of holding more than one type of asset in your investment portfolio. This helps in reducing volatility risks in the financial markets. The assets you hold in your diversified portfolio are not correlated, so their price movements are irrespective of each other.
Types of portfolio diversification
1. Single asset diversification
In this type of diversification, you focus on a single asset but diversify it by investing in an array of the particular asset. It means if you are investing in the forex market, you can choose to build a portfolio with currency pairs that are not at all correlated, like EUR/USD & USD/CHF, EUR/USD & GBP/NZD and more.
This helps you build a portfolio that has different types of currency pairs with a variety of high and low-risk returns. Hence, any increase or decrease in the price of one would not affect the other, balancing your risk-reward ratio.
2. Asset class diversification
Asset class diversification refers to diversifying based on different asset classes; this includes investing in traditional investments like bonds, forex and stocks and non-traditional investments like cryptocurrency CFDs. By investing in contrasting and alternative instruments, you are able to profit from different financial markets that may or may not be directly correlated. Hence, the losses from a fall in one market are balanced out by the profits from the rise of another market.
3. International market diversification
The last way to diversify your portfolio is to look beyond your country’s financial markets. You can include assets from the international market to mitigate risks. So, if something negative happens in your home country, your portfolio is protected against hefty losses as it is diversified by including assets from another country.
This type of diversification may be a little tricky since every country has different rules and regulations, but you can spread your investment across international assets by understanding the processes of the international market.
Steps to build a diversified portfolio
1. Understand the different asset classes
Before diversifying your portfolio, understand the different asset classes and financial markets in which you can invest. From the forex market, crypto CFDs, and the stock market, to the commodities market – there are a number of different investment instruments that are not wholly and directly correlated with each other.
You can build a diversified portfolio by investing in different securities that fit your trading requirements in the best way possible.
2. Spread your wealth across debt and equity instrument
When you have studied the different types of financial markets, it is time to spread your wealth in both debt and equities. If you only invest in equities, the return possibility is high, but so is the risk.
On the other hand, only by investing in debt securities, there is definitely lesser risk but also lesser return. By investing in both, you ensure that your portfolio reaps you high-return possibilities through equities, along with lesser market risk through debt instruments.
3. Allot a part of your investment to fixed-income funds
Investing some of your capital in a fixed-income asset like index funds or bonds reduces your overall risk profile. Bonds and index funds provide a low but fixed return on investment, making your portfolio more risk-averse.
4. Continue building your portfolio over time
Diversification does not only mean that you invest in different securities once and stop. It also means diversifying the timeframe in which you invest. Continue building your portfolio over time by adding more to the existing funds. This helps you profit from different timeframes and market conditions.
By diversifying your portfolio over time, you are able to average out any price peaks and market volatility. Building a diversified portfolio over time also helps in increasing annual returns since you get the opportunity to invest more in the markets performing better. For example, if the forex market is positively impacted due to an economic factor, you can put more funds into it and less in the alternative.
5. Be updated about commissions
Different investment securities come with different commissions. It is essential to keep an eye on the commissions to ensure that your trading cost does not inflate. Always be updated about what you are paying and what you are getting in return.
Whenever there is a change in the commission of an asset, you can either look for alternatives or understand why the change occurred and hold the trade. For example, if the commissions on stocks increase rapidly, you can pull out your investments from it and invest in a stock CFD instead.
6. Exit the trade when required
Just because you are diversifying your portfolio over time and holding onto the trades, it does not mean that you stay in the trade even in unfavourable market conditions. If the market moves against you or becomes too volatile, you can exit the trade to cut your losses and make a new investment thereon.
For example, if your diversified portfolio consists of forex, stocks, crypto CFDs and gold as a metal – and the commodities market begins to decline, you can pull out your investments from it and put it into another security like forex or stocks.
Diversify your investment portfolio as early as possible
To mitigate risk and amplify your profit potential, you need to diversify your investment portfolio as soon as you begin trading. This will not only give you exposure to different markets but help you understand trading different types of markets better.
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Disclaimer:
All material published on our website is intended for informational purposes only and should not be considered personal advice or recommendation. As margin FX/CFDs are highly leveraged products, your gains and losses are magnified, and you could lose substantially more than your initial deposit. Investing in margin FX/CFDs does not give you any entitlements or rights to the underlying assets (e.g. the right to receive dividend payments). CFDs carry a high risk of investment loss.
