How to diversify your portfolio, and why it matters
Markets go down as well as up – in trading, it's the closest thing there is to a law of the jungle. As such, while it's every trader's goal to see the value of their portfolio of investments (all the positions and asset classes they hold at any one time) go up, it's highly likely that not all will rise at the same time.
That's where diversifying your portfolio comes in. In this guide, we'll explore what it means to diversify your portfolio, including the benefits, drawbacks, and how to properly pursue diversification.
What does 'diversify your portfolio' mean?
In short, diversifying your portfolio means not putting all your eggs in one basket. It involves having a variety of different positions across several securities and asset classes open within your portfolio at any one time.
That way, if the value of one security goes down, only a small fraction of your portfolio will be affected. If you had put all your money into that single security, your losses could have been much more severe.
Portfolio diversification is based on Harry Markowitz's Modern Portfolio Theory – that a variety of high-risk investments balance each other out until they reach an efficient level of return versus the portfolio holder's level of risk.
What a diversified portfolio looks like
A diversified portfolio should feature lots of different securities across a range of asset classes. That way, few of your investments will correlate with one another, and therefore only a few will ever drop or rise at once.
There is no one set way a diversified portfolio should look, though; which securities and positions will make their way into your portfolio is up to you and your research. That said, investing in inverse securities can be a fruitful approach: a few growth stocks as well as some value stocks, commodities versus tech stocks, baskets of stocks alongside individual shares, and so forth.
You should also consider your risk appetite. If you're investing and close to retirement, you may wish to keep your portfolio diversified within less risky instruments. The opposite could be an approach if you're much younger, have more time in the markets, and have a higher risk appetite. The Sharpe and Sortino ratios can be effective at evaluating the risk inherent to your portfolio.
What is international portfolio diversification?
International portfolio diversification involves picking positions and investments across a range of global markets, not just your domestic market.
By choosing investments in lower-growth, more-stable developed markets as well as higher-growth, more-volatile developing markets, you can hedge against country, region, and continent-specific economic, business, currency, and political shocks.
This is all while enjoying a higher rate of growth than if you had only invested in developing markets (though at the cost of a higher risk exposure).
To diversify your portfolio internationally, you'll need to keep an eye out for opportunities in emerging markets as well as developed ones and get used to trading instruments like exotic currency pairs.
What are the benefits of portfolio diversification?
There are several benefits available to traders who diversify their portfolios:
- Reduced volatility: The approach of diversification reduces the effects of volatility on your portfolio value over time, as some investments will go down as others go up. This can be beneficial for long-term investors or those who want to avoid being affected by localised economic events.
- Less risk: Having a range of positions open at any one time can help hedge against the risk of your investments all dropping in value at the same time.
- Lowered emotions: For traders used to watching their positions second by second and needing to remove emotion from the equation, having the increased sense of security afforded by diversification can be particularly helpful.
What are the drawbacks of diversifying your portfolio?
Of course, there are a few drawbacks of diversification that every trader must consider:
- Reduced growth potential: Due to offsetting investments against one another, a diversified portfolio will likely grow less explosively than one full of high-risk but high-growth-potential stocks.
- Less likelihood of big returns: Putting all your investment funds into a single security that then grows will naturally deliver higher returns than if you had diversified. The likelihood of this happening may be small, however.
- Increased complexity: With more investments comes more time to understand the rules governing different assets and positions. That means you'll need to put more effort into your homework to stay on top of your investments.
- Higher likelihood of poor investment decisions: By diversifying investments across a wider range of markets, asset classes, and so forth, you're likely to know less about the investments you make. This can increase the risk of making poor decisions, harming returns in kind.
- Potentially higher taxes: While most trades are not typically taxed, such as spread betting, having more investments across a more diverse range of assets can mean increased tax exposure.
Can your portfolio be too diversified?
Yes, your portfolio can become too diversified, and this situation can put your returns at risk.
That's why it's important to look for the signs of over-diversification. For instance: if you've made so many separate investments that assets are beginning to cross over and are too similar; you're invested in hundreds of different stocks and they are difficult to track; or you're invested in assets you have no understanding of.
As such, it's important to regularly take stock of your portfolio: which investments can you sell, and which are best kept?
How to diversify your portfolio?
If you think your portfolio could do with a dose of diversification, there are plenty of ways you can start:
- Choose several asset classes: A mixture of asset classes (shares, commodities, forex, and indices, for instance) will provide you with a range of non-correlated investments that won't move in lockstep with one another.
- Consider baskets: Baskets of stocks or shares can be a good hedge against the movements of individual stocks, given that price moves of a large group of securities will be felt on the macro level, reducing volatility.
- Open a range of positions: A range of short and long positions can protect you against swings in price one way, particularly within a market.
- Constant portfolio growth: As with non-diversified trading, the power of compounding can't be ignored. As such, regularly purchase more of the securities in your portfolio using approaches like value investing.
- Understand your investments: If you don't know what you're investing in, you can't hope to know when to buy or sell, particularly if you engage in fundamentals trading. As such, you must do your homework and understand the various investments that comprise your diversified portfolio.
- Monitor your investments: You will still need to keep abreast of each part of your portfolio, so you know when to buy or sell. Fail to do so and you won't be able to take advantage of profit opportunities.
- Proper analysis: Diversifying your portfolio can and should be done accounting for technical and fundamental analysis – don't diversify at random!
Diversify your portfolio with FXCM today
Now you know how to diversify your portfolio, it's time to trade with the best. FXCM offers traders a huge range of financial instruments to add to their trading portfolios, alongside all the top platforms, tools and know-how needed to ensure you get the most from your investments.
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FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.