Diversifying your portfolio can help reduce some of the risks in trading, as well as help to maximize your returns. Most professional investment advisors will agree that while diversification certainly does not provide any guarantee to prevent losses, it can be a very important element in reaching longer-range income goals while minimizing risk. Most are familiar with the phrase “don’t put all your eggs in one basket”. The same goes for your trading portfolio.
There are two different types of risks for traders …
- Undiversifiable risk. This is also referred to as “market risk”, and is relevant to all markets. Such occurrences as political instability, interest rates, exchange rates, inflation rates, and unknown events (war) … are all undiversifiable risk. This type of risk is not associated with any particular sector or industry, and cannot be eliminated through diversification. Undiversifiable risk is a risk every trader must accept.
- Diversifiable risk. This is also referred to as “unsystematic risk”, and can be specific to a particular industry, market, economy, or country. This type of risk can be reduced through diversification, which is the focus of today's article.
When you diversify your portfolio … by trading different time frames, multiple markets, various strategies, and a variety of underlyings, you can generate more potential sources for profits. Diversifying by industry is also helpful, such as previous metals (gold, silver), airlines, pharmacies, construction, real estate, overseas markets, etc. All of this this helps protect you when the market shifts and puts any one particular strategy or underlying at a disadvantage.
What are some methods for diversification?
For those who are option traders, there are some diversification strategies they may want to consider. Multiple asset classes such as volatility instruments, bonds, stocks, ETF’s which follow the market, and ETF’s which follow the commodities markets can play an important role in protecting one's portfolio. When and if one market moves in a particular direction, the other asset invested in a different asset class may not be affected in a negative manner. Generally, the bond and equity markets move in opposite directions.
Using different types of strategies can be a good method to diversify. For instance, you may want to have directional long and short positions in play on different underlyings at the same time. These can be created as debit spreads, credit spreads, long or short calls and puts. Another good idea is to have some market neutral strategies such as iron condors and or butterflies.
Using different entry and exit times can help diversify …
When a trader buys or sells stock, there is not an expiration date. As long as the company stays in business there is value in the stock.
On the other hand, options have an expiration date which can allow a layer of diversity. This can be accomplished by having multiple positions in play, with short and long term expiration dates. If the positions are entered with different entry and exit expiration dates, it creates a layering effect. If the positions you are trading do not expire at the same time, it may help to reduce risk when there is volatility in the market. Another good quality of layering is all the positions do not expire at the same time which can give you more flexibility.
If the market is moving quickly, the longer term positions may need less attention than the shorter term positions. This can give you the much needed time to react to those positions which need an adjustment or exit.
Cash is a position …
It also makes sense in any trading portfolio to maintain a portion in cash. I am a firm believer of the phrase “cash is a position”. There are times that balance between capital allocated to the market, and cash may shift. Such times are in an extremely volatile market condition where it simply too dangerous to trade any market or asset class. The amount of capital you choose to set aside as cash also depends on whether you are a conservative or aggressive trader, as well as your risk tolerance.
Here are some key points for you as a trader to consider when diversifying your trading business …
However you choose to diversify your portfolio, it is important to remain within your range of experience. It will not help your success as a trader to begin trading any market, asset class, or strategy that has not been thoroughly tested. Remember, diversification only makes sense when you feel it can add unique value to what you are already trading.
It is also important not to over-diversify. This can be related to the popular belief that “more is better”. This is not always the case in trading. If the overall market begins to move quickly and there are too many positions in play, it can lead to difficulty managing the trades. Fear and stress can cause a trader to make poor decisions. Fear can even cause a trader to freeze up and be unable to trade. Over-diversification can result in lower-expected results, and a possible failure to reach your annual income goals.
In summary …
For any business to be successful over time, they must always be innovative, and add sources of revenue to take advantage of changing markets and types of customers. The same principals need to be applied for a trading business to remain successful. Trends change, markets change, and the level of volatility and risk change. Therefore, it is important for a trader to keep abreast of these changes and develop a trade plan which adapts to the market changes.
Think about diversification this way: it is like living a balanced life, where you get the proper mix of things such as exercise, nutrition, work, play, laughter, travel, quiet time, giving, friends and family time. When you diversify your life and have the proper mix of all of these elements, you're more apt to have a happier life.
Of course, creating a balanced life does not provide any guarantees that it will lead to a longer life; but it can help. The same goes with diversification in trading – there are no guarantees that by diversifying your portfolio you will not incur any losses, but diversifying can, at the very least, spread that risk over a variety of sources. When you diversify your trading business, you are more likely to experience better results over time.
However you choose to diversify your trading business, do your due diligence so that you are comfortable your trade plan has enough potential income sources to weather storms that you may encounter along the way. There is no specific model or guideline for diversification that will meet the needs of every trader. Choose your method so it aligns with your own tolerance to risk, and overall income goals. If, when researching methods to diversify your portfolio appear overwhelming with too many choices, consider consulting with a fellow trader or financial advisor who may help you in your decision-making.
If you have a specific mix of diversification that has helped you balance your portfolio and would like to share, feel free to comment below.
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