You’ve probably heard more than once that it is essential to diversify your trading portfolio with different assets. But what does it mean to diversify and why exactly would you want to do it?
Diversification is a process of adding unrelated assets to your trading portfolio. Correlated assets, no matter how thoroughly-picked, will provide similar results under similar market conditions. The latter poses an additional degree of risk. Imagine all open positions going down at once — this is not something you want from a well-balanced portfolio. Unrelated assets, on the other hand, will provide different results following a particular event and there is a chance that while one of your assets is going down, the other will go up.
Risk management, therefore, is the primary reason to diversify but is not the only one. Read more about the three reasons below.
1. Risk management
Risk management is probably the first thing that comes to mind when talking about portfolio diversification. Indeed, when trading unrelated assets, you lower your chances of losing a considerable amount of money all at once due to a single negative event. Imagine keeping all your money in automotive stocks, say, Tesla, General Motors, Ford Motor Company, etc. In this case, when all auto manufacturers from the United States are suddenly hit with restrictive tariffs from other countries, their shares will go down in price, all at once.
Portfolio diversification aims to solve this exact problem. When you invest in unrelated assets your chances of losing on all of them decrease dramatically. And still, it is possible to take the whole thing one step further. Instead of buying and selling different stocks, you could trade different asset classes — for example, currency pairs, CFDs on stocks, indices, commodities, etc., as this could diversify your portfolio even further.
2. New horizons
A lot of traders — including the most successful ones — focus on one asset type. George Soros is exceptionally good at trading currencies, while Warren Buffett has made his fortune by investing in stocks. Similarly, there are traders who primarily work with precious metal, oil, exchange-traded funds, etc. Your trading strategy is heavily influenced by your personality, and different assets can yield different results depending on the trading strategy you use. In order to find what asset suits your trading style and strategy, you would first have to try as many of them as you can. You might want to dig into different instruments at least once because it can greatly broaden your trading experience and help you find the asset type that suits you best.
3. Non-stop trading
Not all assets are traded 24/7. Forex, for example, is only available Monday to Friday (but at least it can be traded during the night). Stocks, on the other hand, are traded during particular hours, when a corresponding stock exchange is traded. Tesla, listed on the NASDAQ stock exchange, can only be traded from 9:30 a.m. to 4:00 p.m. Eastern Time. The same applies to other exchange-traded companies and funds.
By diversifying your portfolio, you can trade at times when the primary asset of your choice is not available. Say, if you are a fan of stocks, you can trade them during the market hours and then switch to Forex when the stock exchange is closed. While one of the assets is down, the other can be readily available for trading and you won’t miss trading opportunities the market has to offer.
