How to diversify your portfolio: Risk-management strategies How to diversify your portfolio: Risk-management strategies How to diversify your portfolio: Risk-management strategies

How to diversify your portfolio: Risk-management strategies

Trading Strategies

Saxo Group

Diversification can be a useful way to manage risk when trading and investing, but what does it mean and how do you do it? This guide will explain the basics of diversifying your financial portfolio, and why it’s important. However, before we get into all of that, let’s start from the beginning and outline what we mean by the term “portfolio”.

What is a portfolio?

A portfolio is a term used in investing and trading to describe a group of financial investments. It’s your collection of holdings.

One way to think about your portfolio is that it’s like a cake. The cake has various ingredients, and these ingredients have different functions. They are distinct in their own right, but they also interact with the other ingredients to create something new (i.e. the cake).

Your financial portfolio is similar. You can have many different ingredients (i.e. types of investments) and each one is distinct. Yet, they’re all linked by the fact they’re part of a single portfolio. So, while the performance of one ingredient won’t have a direct impact on any other, the performance of each ingredient will affect your whole portfolio.

The whole is greater than the sum of its parts

Let’s explain this with an example. You decide it's time to start trading. You understand that the value of your investments can go up and down. You start by buying stocks in a few companies. These stocks are the first ingredient. Things go well and you decide to buy some forex. Finally, you invest some spare money into commodities. 

Now, you’ve got three key ingredients: stocks, forex, and commodities. Each ingredient can be further divided into individual assets, e.g. you can have stocks in different companies, trade multiple currency pairs (forex) and invest in a selection of commodities such as oil and gold. Let’s focus on each ingredient (stocks, forex and commodities) as an individual asset that’s distinct from all the others. 

Each investment is its own thing, but they’re also part of the same portfolio. This portfolio is the total of your investments. Therefore, even though each one is distinct, they all impact your total investment, just as each ingredient affects the taste of a cake. 

Distinctions and connections matter 

These distinctions and connections matter. For example, let’s say your stocks and forex are making a profit, but commodities aren’t. In their own right, commodities are negative. 

However, because these investments are connected to stocks and forex by virtue of being part of your portfolio, the negative might not matter because gains elsewhere will cancel out the losses. 

You can see why a diverse and balanced portfolio is necessary. Your profit/loss is the sum total of all the investments in your portfolio. So, while the definition of a portfolio is easy to understand, you need to go beyond the basics to master the art of diversification. 

You need to understand the interplay between your investments and how they’re separate but also indirectly linked. Only once you’ve grasped this duality can you implement your own diversification strategy.  

What is a diverse portfolio? 

A diverse portfolio is when you have a collection of investments that span a variety of assets and markets. Going back to our previous example, a portfolio that contains stocks, forex and commodities is diverse because the investments cover different markets. It’s also possible to diversify within a single market. 

For example, you could invest in stocks but focus on different industries. You could have a selection of tech stocks, as well as stocks in energy companies, healthcare companies, and utility companies. These investments are stocks. 

By focusing on a variety of industries that aren’t directly linked, you’ve introduced an element of diversity into your portfolio. However, if we stick to a strict definition of diversity, the focus is on multiple investments across a range of markets, a.k.a. asset classes. That’s the practical definition of diversification. On a theoretical level, diversification can also be defined as a risk-management tool.  

So how can you use diversification to manage risk?  

Reasons to diversify your portfolio

Spreading your investments across asset classes also means spreading your risk. Indeed, the reason to diversify your portfolio is to try and counteract losses in one area with gains in another. But always remember that you can never actually eliminate all risk. 

Losing money is always possible even if you have a diverse portfolio. However, by spreading your interests across a variety of markets, it’s possible to reduce your potential risks. The performance of your portfolio is the sum total of its parts. You always want each investment to make a profit. 

Some will lose money. But, if you can create a diverse portfolio that contains investments across a range of markets, you’re creating a sense of balance. Doing this can help you stay on a positive trajectory even when certain investments are decreasing in value.  

Again, it’s not a guaranteed way to make a profit and there could be times when a diverse portfolio is losing money. But diversification can reduce your potential losses when certain markets become bearish.  

Four tips for creating a diverse portfolio 

When building a diverse portfolio, you can’t simply put money into a few assets and hope to make a profit. You need a strategy. So here are four tips to consider when you’re diversifying your portfolio: 

1. Look for distinct investments 

When you begin to create a diversified portfolio, the first thing you need to do is build a solid foundation. This foundation needs to contain a varied selection of asset classes. By varied we mean that the asset classes can’t be too closely correlated. 

It is possible to have a diverse portfolio of stocks, but look closely at the stocks you choose because the best way to diversify is to focus on a variety of markets.  

The goal is to invest in assets that have low or negative correlations. With weak or no links between your investments, there’s scope for each one’s value to move independently. When one asset is up, another could be down. 

Of course, it would be ideal if all the assets were up in value. However, in the absence of this happening, you want to make sure that a bearish market for one asset doesn’t create a bearish market for other things in your portfolio. That’s not easy, given that many parts of the financial world are linked. However, it is possible to have investments with relatively few connections. 

For example, you could hold stocks in Microsoft and Apple. You could also have investments in oil and gold. Although we can debate the macro implications of oil prices and how they can affect all companies, the links here aren’t very strong.  

In reality, the price of gold and oil can drop, and this won’t typically affect Microsoft and Apple stocks. 

This is the thought process you should go through when you’re building a foundation for your portfolio. If the correlations between the two investments are high, it might be worth considering something else. That’s not to say you can’t have investments with strong correlations in your portfolio. However, there shouldn’t be many of them. The weaker the connections, the more diverse your portfolio will be and the greater risk-management you can achieve. 

2. Think about costs and fees 

Different assets incur different costs and fees. Our pricing overview gives you an idea of the low fees you’ll pay at Saxo when you invest in different markets.  

As well as broker fees, you need to think about your total stake and the varying costs of each asset. Only you know what a realistic budget is. The general rule is that you shouldn’t invest money you can’t risk losing. Once you’ve got a figure in mind for your total investment, you need to think about how much you’re going to put into each market. 

Again, this is a matter of personal preference. However, let’s say you’ve got USD 10,000 and you want to invest in stocks, forex and commodities. You do some research, listen to expert advice and decide you want to put 50% into stocks, 30% into commodities and 20% into forex. These percentages could change over time. However, they can be used as a starting point. In this example, you’d allocate USD 5,000 to stocks, USD 3,000 to commodities and USD 2,000 to forex. 

3. Keep adding to your portfolio with dollar cost averaging 

Your investment portfolio should be a living organism. It should be constantly growing and developing. This is where dollar cost averaging can be useful. Dollar cost averaging is where you invest money into a portfolio over a sustained period. That means you don’t put all of your money into something at once. 

For example, let’s say you’ve got USD 10,000 to invest. There are no rules against investing all of it at once. However, if you do this, you’ll have to take whatever the latest price is/prices are. It could be a good price; it could be a bad one. It’s impossible to know and you have to rely on the market moving in your favour. 

With dollar cost averaging, you’d start by putting in a certain amount. Let’s say you invest USD 2,000 in stocks, forex and commodities. This leaves you with USD 8,000 to invest. From this point, you’d commit to investing the same amount over a specified time. Let’s say 10 months. That means you’d invest USD 800 into your portfolio every month for 10 months. 

The price you’ll pay for each asset in your portfolio will vary over 10 months. Some months you’ll get better prices, some months you’ll get worse prices. This means, in theory, you should get the best average price because you’ve spread your investment. By averaging out your investment over a long period of time, you’re smoothing out the natural ups and downs of the financial markets. 

This strategy can help you get the best overall price for the assets in your portfolio and help it evolve. Investing and trading aren’t static events. They’re dynamic. You should be continually looking for new opportunities and capitalising on existing ones. So, once you’ve built a diverse portfolio, the next step is to add to it by employing strategies such as dollar cost averaging. 

4. Don’t go on autopilot 

There’s nothing wrong with holding long positions. However, in line with our previous point, you shouldn’t remain static. Investing in multiple assets and creating a diverse portfolio is the first step. It’s not the final step. You can’t go on autopilot and hope that your diverse range of investments will look after themselves. 

You need to monitor each position and its impact on your portfolio. If you need to buy more of something because it’s performing well, do it. If you need to sell an underperforming asset, do it. Becoming stagnant and not actively monitoring your portfolio is a recipe for disaster. Therefore, once you’ve built a foundation that contains a diverse range of assets, you need to be ready to add/remove assets. Get this right and you’ll maintain a diverse portfolio that has the potential to keep making money. 

Build a diverse portfolio 

A diverse portfolio involves a collection of financial assets from a selection of classes (markets) that aren’t closely correlated. Creating a diverse portfolio is a way of reducing risk because certain investments could be bullish while others are bearish. Thus, if the bullish investments are strong enough, they’ll cancel out losses from other assets in your portfolio. 

That’s the theory. Combine this with our tips for building a diverse portfolio and you should be on your way to trading like a professional. The last thing to cover is how to build a diverse portfolio. 

These are the steps you can take to vary your investments: 

  1. Create an account at Saxo Bank. Use the free demo account to familiarise yourself with the trading software and master the basics of buying and selling. 
  2. Make a deposit. This can either be your total bankroll or a portion of it. 
  3. Scroll through the list of products we offer and think about how they’d interact/won’t interact within your portfolio. The products available at Saxo Bank are: forex, CFDs, futures, commodities, stocks, bonds and ETFs. 
  4. Invest in your chosen products. Keep in line with your bankroll constraints. 
  5. Actively monitor your portfolio so you can remove assets that are performing poorly, capitalise on bullish investments and add new assets. 

If you follow these steps, and consider the fundamentals of diversification, and do your research, you will have a greater chance of succeeding in your trading and investing journey. 

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