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The Importance of Portfolio Diversification and Allocation in Trading

The Importance of Portfolio Diversification and Allocation in Trading

calendar 27/03/2023 - 05:57 UTC

Trading is not gambling; having a hunch and betting a bunch is a quick way to risk ruin. One of the best ways to manage your risk is to ensure that all your eggs are not in one basket. Allocating your assets and diversifying are two money management techniques to ensure that you have a portfolio that can withstand an adverse market change. The upshot is that diversification and asset allocation reduce your risk. While it is not guaranteed, this technique could help you reach your long-term financial goals while reducing the volatility of your returns.

What is Risk?

All investments have risks to some degree. Risks can include that someone will pay you back or the price of the asset you purchase moving lower. It can be that there is political instability or a systemic risk that takes down a company or country. Even the risk-free rate of return, the returns U.S. treasury bills reflect, holds the chance that the United States will not pay its bills, which can be happy (theoretically). Regarding directional trading, price risk is one of the most critical exposures an investor faces. Risk is not losing money or a portion of your portfolio; it's the likelihood of losing money.

One of the most important concepts surrounding risk is that your returns are generally based on the risk you assume. The more significant the risk, the greater the potential reward. If you take no risk, you should assume that the most you will receive are the risk-free rate of return. One of the keys to taking a risk is to take a diversified risk, which means that one event or market reaction will not generate a gain or a loss that will generate the risk of ruin.

There are several ways to mitigate risk. If you are trading a single position, the best way is to have a stop-loss order so you will have a clear idea of how much you can lose on any individual trade. You can place a stop-loss order with your broker to unwind your position at a specific price level.

What is Risk Managment?

The concept surrounding risk management is that you will limit your risk, allowing you to generate returns without unlimited exposure to the change in the price or the exchange rate of an asset. The practice of risk management is identifying the possibility of risk and figuring out how to mitigate that risk. Risk can come from several sources. Most of the time it's possible to identify the potential causes of risk, but occasionally it's not possible. For example, it would have been hard to predict that COVID-19 would spread across the globe and create supply chain disruptions. Regarding political risk, elections are generally scheduled, and though an outcome can be unlikely, it is always possible.

What is Asset Allocation

If you are trading multiple positions, you want to ensure that you allocate your assets to favorable strategies and investments. The first step you need to take is to set financial goals and determine if the systems and assets that you trade will provide you with the returns you are looking to achieve.

Asset allocation is an investment technique using separate return profiles to generate an average return for all of your investments. An example might be the classic 60% - 40% split that money managers use to achieve long-term investment goals. A 60%-40% split refers to the amount of your portfolio that should be split into stocks and bonds. Since stocks usually outperform during an expansion and bonds usually outperform during a contraction, the split provides an investor a return during an upturn in economic activity and a contraction in economic output.

Your asset allocation could include stocks, bonds, commodities, forex, cryptocurrency, and even real estate. Some people even collect art and wine as investment assets. If you want to experience robust returns, you want to have exposure to assets that are volatile and move around frequently. A volatile asset will generate returns that are positive and negative. The term volatility refers to the standard deviations of the returns over a specific period. If you want smoother, less robust returns, you likely want to veer away from volatile assets. The combination of investments you choose will give you the total return you receive.

What is Diversification – How to Diversify Your Portfolio

The allocation of your assets is one way you can use risk management to manage the risk in your portfolio. Within the assets that you manage, you also want to diversify. A diversified portfolio has a mix of assets, attempting to limit your exposure. The technique will also generate a higher yield over a long period as you will unlikely face a significant drawdown.

You want to ensure that each asset is diversified within a mix of assets. For example, if your asset allocation is to purchase 60% of stocks, you want a diversified basket of stocks, not just one. If you own just one stock and there is an adverse event such as bankruptcy or negative news, you could face a large drawdown. You might diversify by investing in different sectors, such as energy, technology, or financials. You can also invest in large-cap or mid-cap, or small-cap stocks.

Another type of diversification is your strategies. You might use a buy-and-hold strategy for some securities while you trade actively for other strategies. By having some trading methods as trend following and others as momentum technical trading strategies, you are diversifying your trading techniques and removing some of the risks that a trend would fail. By using a fundamental trading process and a technical analysis trading method, you are reducing the risk that one of your strategies does not work as expected.

Some investors are partial to growth stocks, while others want to invest more in value stocks. You can consider investing in your domiciled country or foreign investments. Diversification is an attempt to reduce the risk events in a portfolio so that the positive performance of an investment neutralizes the negative performance of other assets. The goal of a diversified portfolio is that the assets that you choose are uncorrelated to each other.

What is Correlation?

Correlated returns are those which move in tandem with each other. If two assets move in lockstep, the correlation is 100%. If two assets move in the opposite direction, the correlation is negative 100%. If two assets have no observable movements that can be recognized, the correlation is labeled as zero. Having assets in your portfolio that have no or low positive or negative correlation is beneficial as they will not move in tandem during an adverse market condition. The positive returns will offset the negative returns, and the returns will hopefully be positive over time.

An example of How a Diversified Portfolio Would Work

An example of how a diversified portfolio would function could be the purchase of the S&P 500 index and fine art. According to sources, the art market and the S&P 500 index do not correlate. So, an adverse situation in the art market should not impact your stock portfolio. Corporate bonds also have very little correlation to the S&P 500 CFD. Determining what is CFD trading and the relationship of assets to the S&P 500 index helps determine your diversification. You can purchase corporate bonds or an exchange-traded fund (ETF) holding corporate bonds such as LQD. Treasury bonds also have very little correlation to stocks. You can buy treasury bonds or an ETF that holds treasury bonds.

The Bottom Line

The upshot is that diversification and asset allocation are risk management techniques. Risk management is a tool often used to mitigate the risks associated with changes in the prices of investment securities. While there are techniques like a stop-loss order that you can use to limit your risk on an individual trade, diversification, and asset allocation are tools used for risk management on a portfolio level.

Asset allocation is placing your funds in different assets to ensure you do not put all of your eggs in one basket. If there is an adverse market change, having lots of investments is safer than having one specific security.

Having a diversified investment strategy is very important. You can have different assets such as stocks, bonds, commodities, and techniques such as trend following, momentum, and fundamental trading methods. You should also consider the option of having some of your assets uncorrelated so that if an adverse move comes, the gains in one asset will offset the losses in another investment. Your objective is to reach your long-term financial goals by ensuring that your investments work in all market environments by having a diversified basket of assets.

The materials contained on this document should not in any way be construed, either explicitly or implicitly, directly or indirectly, as investment advice, recommendation or suggestion of an investment strategy with respect to a financial instrument, in any manner whatsoever. Any indication of past performance or simulated past performance included in this document is not a reliable indicator of future results. For the full disclaimer click here.

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