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Diversification is key to keeping your portfolio balanced, especially during periods of economic downturn. Find out what it means to diversify your portfolio, how to do it, and what impact it has on your risk-to-reward balance.
Building A Diversified Forex Portfolio For Long-term Profits In Singapore
Diversification is the practice of opening multiple positions in a number of asset classes. It aims to limit exposure to a single type of risk. Investors and traders use the strategy to create a more balanced risk profile and maximize long-term returns.
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A diversification strategy can include positions across industries, asset classes or even different financial instruments, such as using CFDs, spread betting, options or futures.
The key to a successful diversification strategy is to ensure that the assets in your portfolio are not correlated with each other. This means not only diversifying across asset classes, but also within each type of asset class.
The main purpose of diversification is to improve risk-adjusted returns, which is the degree of risk you must take to make a profit.
It does this by minimizing or neutralizing the effects of negatively performing positions. So, in the event of an economic downturn, when some positions start to lose, other areas of your portfolio are preserved or increase in value.
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You will face a number of risks when trading the financial markets, which generally fall into two categories: diversifiable and non-diversifiable.
The first type of risk, as the name suggests, can be reduced through the diversification strategy. It is also called unsystematic risk as the exposure differs by company, industry, market or country. Because each investment area is unique, you can mitigate the impact of risk on your capital by investing in multiple assets.
The second type of risk cannot be diversified away as it is associated with each company or asset, regardless of industry, market or country. Non-diversifiable risk is also known as systematic or market risk. Because it is not a specific type of risk, it is difficult to identify and prevent. So it’s just something that traders and investors have to agree on before opening a position.
Because not all risks are diversifiable, it’s important to understand exactly how your portfolio is exposed to different risks and how you can protect yourself. For non-diversifiable risk, hedging is a popular alternative strategy used to offset a portfolio’s loss.
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While diversification reduces portfolio risk and offers long-term growth potential, it can limit short-term growth. Opening many different positions will incur costs, so it is important to assess how much you can afford to give to this strategy.
You’ll also be committing time and capital, as diversification requires regular monitoring of your portfolio’s health. Some investors choose to open fully managed portfolios, to pass this responsibility on to a professional.
While most asset classes can be used to diversify your portfolio, there are a few that are continually popular with investors and fund managers. This includes:
Shares are the units of ownership in a publicly traded company. It is important to diversify in the stock market, taking into account factors such as market capitalization, sector and geography. You just need to make sure that the stocks you choose are affected by a number of different factors.
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A common method of stock diversification is to select some cyclical stocks and some defensive stocks. Cyclical stocks are those that rise and fall in line with economic growth, often outperforming in periods of health when investors are most optimistic. Although defensive stocks retain their value regardless of the economic cycle, making them a useful safety net for a diversified portfolio.
Exchange-traded funds (ETFs) are investment vehicles that track the performance of a group of markets. ETFs are passive instruments, meaning they reflect the returns of the underlying market and will not outperform it.
Choosing an ETF instantly diversifies your portfolio more than most asset classes because you’ll have a position in multiple markets. For the most part, ETFs track assets in the same pool, for example a sector or country index.
When determining which ETF to choose, you should research its composition, asset mix, and past performance. You can do this by reading the ETF’s prospectus or Key Investor Information Document (KIID) before taking a position.
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Bonds are fixed income instruments that represent an amount of debt. They are usually issued by a government or corporation, promising to pay an investor regular interest payments until the loan is repaid.
There are so many different types of bonds available that it is an extremely effective way to diversify a portfolio. Bonuses can vary in:
Commodities can be a useful diversification asset as they often have a low correlation with stock and bond returns.
Commodities tend to have a different business cycle than the rest of the economy, which means they can be used as a hedge in the event of a recession. The most common example is gold, which has been used as a safe haven for decades. However, this is not a hard and fast rule, so it is important to research how the markets have behaved in the past.
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Some commodities are also considered consumer staples, such as defensive stocks, meaning they are needed regardless of the state of the economy. Examples include food and energy.
The most important consideration is how to get exposure to the merchandise. Many traders and investors use futures contracts: an agreement to exchange an asset for a set price on a certain date. Although there is an obligation to settle a futures contract, this can be done in cash rather than physical delivery. Therefore, futures can capture market sentiment around commodity prices, without the need to take ownership of the underlying commodity.
Another popular way to diversify commodity portfolios is through ETFs, which offer much broader exposure to a variety of commodities, including precious metals, industrial metals, energy and agricultural products.
Even among diversification strategies, there are risk and lower risk profiles. As an easy way to see how diversification and asset allocation affect risk and reward, let’s look at the five categories of smart portfolios.
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Each of these portfolios will experience different returns and be affected by volatility in different ways, as you can see in the table below:
More risk-averse portfolios have lower “best” returns but slightly lower “worst returns.” Meanwhile, portfolios with higher hh risk outperform in periods of growth, but suffer more severely in downturns. The balanced portfolio, which emphasizes diversification, sees a happy medium.
To calculate the risk-adjusted return of your portfolios, you can choose a few methods. Two of the most popular are the Sharpe and Sortino ratios.
The Sharpe ratio takes the portfolio’s average return, subtracts the “risk-free rate” (explained below), and divides the difference by the total volatility of the investment.
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The risk-free rate of return is the theoretical return that an asset would have with fixed interest payments, without you assuming any risk. In practice, there is no such thing as a risk-free investment. However, Treasury bills are commonly used as a measure of a risk-free rate. To calculate your risk-free rate, you’ll need to subtract the current rate of inflation from the yield on the bond that has the same duration as your investment.
Eliminating the risk-free rate will help you see if a riskier approach is worth it compared to different portfolios. The Sharpe ratio is a positive measure of volatility; therefore, the higher the value of the Sharpe ratio, the more attractive the portfolio’s returns would be.
The Sortino ratio is similar to the Sharpe ratio, but instead of considering a portfolio’s upside risk, it only considers downside potential.
Critics of the Sharpe ratio argue that it only gives an understanding of the positive volatility that drives returns, which is what investing is all about. Therefore, by looking at the downside risk that comes with volatility, you can get a clearer picture of your risk-adjusted performance.
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To calculate the Sortino ratio, you should take the difference between the portfolio’s return and the risk-free rate and divide it by the standard deviation of negative returns. Whatever the ratio of Sortino, the better; this means that the more risk you take, the more your portfolio earns.
To better understand how
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