How to use portfolio diversification to tackle risk
Reading time: 8 minutes
Every so often, events occur that are so earth-shaking they send reverberations to every corner of the market.
Fortunately, events of this magnitude are rare.
Most of the time, there tend to be different factors affecting different parts of the market.
Therefore, the chances of many independent markets being adversely affected at the same time are fairly small.
Herein lies the heart of portfolio diversification theory.
Diversification is all about choosing to invest in several different areas of the market…
...in order to reduce the risk of your overall portfolio being adversely affected by any one factor.
In other words, by choosing our asset allocation wisely, we can seek to shelter ourselves from risk.
Portfolio diversification and risk reduction
So, the effect of portfolio diversification on risk is to reduce it, but we should note this doesn't apply to all types of risk.
Of course, when we trade there is always some inherent risk...
...that's just the nature of the beast and there are limits to the effect of tactical portfolio diversification.
It's important here to qualify exactly which type of risk it is that we reduce with diversified portfolio strategies.
So let's introduce the concepts of systematic risk and unsystematic risk.
Systematic risk is the inherent uncertainty of the entire market and therefore cannot be mitigated by building a diversified portfolio.
Unsystematic risk describes the types of risk that we can protect against, at least to some degree, by selecting a well-diversified investment portfolio.
Occurrences that disproportionately affect one company, sector or type of instrument are examples of unsystematic risk.
Think about a stock market investor who is building an investment portfolio.
If their investment allocation is varied, then news affecting one sector will affect only some of the stocks in their portfolio.
In other words, their diversified investment portfolio helps to cushion against the effect of specific bad news.
Failing to have a sufficiently diversified portfolio is akin to the well-known idiom of putting all your eggs in one basket.
For example, consider an investor whose investment allocation focuses solely on energy sector stocks.
If OPEC decides to increase oil output, it could depress the value of the entire portfolio.
Now, consider if the investor had a cross-section of companies from a variety of sectors instead.
This would ensure a portion of the portfolio was less exposed to the sudden changes in the energy sector.
Here you have the answer as to why portfolio diversification is so important.
An investment diversification strategy seeks to take positions in sufficiently different instruments, so as to lower your exposure to risks tied to specific slices of the market.
That said, if you look back at the financial crisis in 2008…
...it wouldn't really matter how well you had employed CFD portfolio diversification if all your positions were in equities.
This is because the systematic nature of the problem stressed all sectors of the market.
Share prices as a whole moved sharply lower, along with other investments, such as house prices.
Events such as war, interest rate changes and economic slumps tend to affect the whole market and can't really be protected against via tactical asset allocation.
The main strategy for protecting against this type of risk is hedging.
You can read more about this in our article What Is Forex Hedging.
Why is it important to diversify your investment portfolio?
Diversification is important in investing because it reduces the chance of an adverse factor affecting the whole of your portfolio.
Trading profitably is all about winning in the long run.
You cannot win in the long run if you experience a drawdown severe enough to stop you trading.
Diversification helps avoid this negative scenario.
Is there an advantage of portfolio diversification beyond just trying to diminish risk though?
The answer is yes.
Three benefits of portfolio diversification:
- reduces risks tied to specific assets classes
- increases the chances of encountering conditions favourable to your system
- delivers more signals
Let's consider a trader who only looks at a narrow set of currency pairs.
Let's say they are a trend-follower who only considers trading EUR/USD and GBP/USD.
If these currency pairs are range bound for an extended period, the trader isn't going to have any signals to trade on.
Now consider the trader who looks at a diverse range of markets.
This trader is likely to receive more entry signals.
But beyond that, trend following is all about finding a big winning trade amongst more frequent, smaller losing ones.
By exposing themselves to more markets…
...our trader has increased the chances of encountering the favourable market conditions required for a big winning trade.
In this case, they have widened the odds of finding a persistent trend.
If you're looking to hold a number of financial instruments, the same principles of risk-balanced portfolio construction apply.
So if you're a commodity trader…
...you'll be wise to consider some kind of commodity diversification.
Of course, proper portfolio diversification also involves spreading your risk across multiple asset classes.
If you hold diversified financial investments, the less likely you are to be overly exposed to one risk area.
This means with the right kind of tactical investing you can achieve some simple reduction in overall risk.
So how to decide your portfolio allocation?
As is usually the case with trading, the question really depends on the individual.
What are you trying to achieve?
If you are risk averse, then portfolio diversification will be a big issue for you.
Diversified portfolio example
With a stock portfolio, it is quite easy to construct a diverse selection, where you can mix and match from different sectors.
When it comes to Forex portfolio diversification, it can seem less straightforward.
Generally speaking, though, what we are trying to avoid is this:
...trading in the same direction on a number of currency pairs that are correlated.
If we can do this, then we have gone some way toward achieving a more balanced investment portfolio.
So, how can we tell which Forex pairs are correlated?
Here's where MetaTrader 4 Supreme Edition is really handy.
The MT4 SE plugin offers you a greatly enhanced suite of indicators and trading tools.
Among these tools is the correlation matrix.
The correlation matrix allows you to see at a glance the strength of correlation between currency pairs.
It also allows you to view the correlation in different time frames.
So, some simple tips for a portfolio diversification strategy:
- check correlation in multiple time frames
- avoid trading in the same direction on strongly-correlated pairs
- alternatively, actively trade in the opposite direction on strongly-correlated pairs
- avoid similar positions involving currencies from the same regions
- diversify further by holding positions over differing time frames
- also, consider diversifying your strategy style.
Overall, the idea is to strip out commonalities between different positions in our portfolio.
For example, if you were considering going long AUD/GBP and NZD/USD…
...you might only choose one of the two in the interests of diversification.
This is because NZD and AUD are both currencies from the Oceania region.
We might reasonably expect them to be similarly affected by factors specific to that region.
The final point in the list above refers to the actual trading strategy you are using.
You might find that a certain strategy only offers a few signals per month, while another offers 20 or 30.
Dividing up your available risk capital amongst these strategies might help to complement each other.
An excellent way to practice these techniques and work out what is the right mix for you is with our risk-free demo trading account.
This way, you can try out your strategies first and see what works best before you try trading with real money.
A final word on portfolio diversification
We've looked at the basics of diversification, just one of a number of foreign exchange risk management strategies.
You can very easily take these ideas and tweak them further so as to achieve greater Forex portfolio optimization.
Remember that investment diversification is not a guarantee against loss…
...but it can be considered a broad safety net to help cushion against residual risk.
Also, remember that the objectives of portfolio diversification is to protect the sum of the whole.
So even if you have diversified investments, individual segments of that portfolio are still going to be at risk.
This is why it always makes sense to utilise other good Forex risk management strategies with every individual trade.
Consider stops, sensible money management, etc.
Finally, you should never diversify into areas that you don't understand.
There is an argument to be made for keeping your focus within your area of specialty, so don't feel obliged to diversify for the sake of it.