Many investors think of “diversification” as synonymous with the old adage, “Don’t put all your eggs in one basket.” While the two ideas are similar, the adage (which is heavily bent toward the more defensive side of asset allocation) is only half true when it comes to the benefits of diversification. There’s a missing component, a crucial one. And that’s the ability to pursue market opportunities that are timely and emerging.
Not Just a Hedge, But an Additional Return Source
Balancing defensive diversification…
Let’s rewind and take it slowly. If you want to hedge your portfolio—that is, protect your assets from marching in a single file down the value drain when a market tumbles—then it helps to hold a wide variety of non-correlated assets. This term is just a fancy way of saying that if one asset declines, other assets either won’t decline as much, or they’ll stay the same. Even better, they could do the opposite and rise in value. That’s the defensive aspect of diversification.
…with productive diversification.
But as you hedge, you’re also opening yourself up to the possibility that a given financial instrument, asset class, industry, sector, market, or country might pull ahead of its financial “peers”—correlated or not. In other words, you are putting additional return sources in your portfolio that proverbially “scout” for new opportunities that could unfold in a market or economy. That’s the productive (or “aggressive”) aspect of diversification.
Considering the two, who wouldn’t want both value protection and value proliferation?
Start Diversifying Your Portfolio
So, what’s the ultimate goal of diversification? To set yourself up in such a way that your positive payoffs significantly outweigh your negative returns. While some assets fall as others rise, you want your rising assets’ growth rate to be more substantial than your declining assets’ rate of decline.
It’s cyclical, but one that expands your wealth gradually while reducing your overall portfolio volatility and losses.
How Many Ways Can I Diversify?
How many ways can I diversify my portfolio? The simple answer is “quite a few.” We’ll skip the more traditional approaches, as most investors already know about it. For example, if you own a tech stock (exposed to a single company’s business risk), then you hedge it by buying another tech stock but in a different tech “industry.”
Want to hedge that? Then choose stocks out of any of the other 10 sectors. Worried about holding too many stocks? Then add bonds to the mix. You can also add a vast range of commodities as well.
But perhaps you need an even higher level of diversification. Of all the directions we can go to add that next level, let’s talk a bit about foreign currencies and trading systems.
A Counterpoint of Currencies
When it comes to diversifying your portfolio, everything comes down to one factor: correlation. This refers to how one thing (in this case, an asset) is related to another.
Highly-correlated assets tend to move together: if one goes up, the other follows, and vice versa. The weaker the correlation, the weaker the similarity in market movement. Negatively-correlated assets, such as the US dollar and gold, often move in opposite directions with one going up, and the other going down.
If you are looking to diversify a portfolio of stocks, bonds, and even most commodities, you are sure to find plenty of non-correlated assets in the forex market. You just have to check the fundamental factors sustaining or driving non-correlation, and you have to choose wisely with regard to a country’s economic position and forecast.
Say you’re well-diversified in financial securities (stocks and bonds). These are dollar-denominated assets. As you know, the dollar has been sinking, eroding your money’s purchasing power. You can invest in gold, which is negatively correlated. But if you don’t want to jump into an asset that is currently at all-time-highs, then you might look across the shores to countries whose currencies are “down but not out.” Some good examples include the EUR/USD, AUD/USD, NZD/USD, or USD/CAD (short the greenback, long the loonie).
These are just four of multiple currency pairs you can choose from. The big caveat here is that you’ll have to do your fundamental homework—and a lot of it—especially if you’re looking to hold any of these currencies for the long haul (trading them for short-term game is another matter, and a completely separate article).
And what if, like most investors, you’re new to the forex market? You can always ask an investment professional. Or, you can add yet another layer of diversification, not just with currencies but with currency trading systems: “system diversification.”
System Diversification: One to Balance the Other
A trading system that focuses on a given currency pair, say, the EUR/USD, is one way to diversify any portfolio holdings that aren’t correlated with Euro exposure (like most assets held by US investors).
That’s fine. But can you diversify one EUR/USD system against another? Absolutely. Let’s imagine a long-term “trend following” system that trades (long and short) the EUR/USD. Its performance will likely differ from another Euro-based “day trading” system that seeks to profit multiple times intraday. And both systems might differ tremendously from another EUR/USD “swing trading system” that opens and closes positions over a matter of just a few days.
Get the picture? What you’re diversifying here is not the currency or market, but the “strategy.” In short, holding different strategies, even within the same currency pair, can yield completely different results—hence, a legitimate form of diversification. This, of course, works as long as the strategy is reasonable and sound; keep your profit factor and risks within your range of preference and tolerance.
The Bottom Line: Do Your Research
If your aim is to diversify your portfolio, it helps to look at all of the options available to you. This means going far beyond the traditional “go-to’s” such as stocks, bonds, and commodities.
Countries offer diverse investment opportunities, specifically their currencies. But to add that extra level of diversification, it helps to look at a palette of different trading strategies, whose varying performances can add non-correlated returns to the mix, allowing you to create a more sustainable investment portfolio and one that exponentially expands your market opportunities.
Many investors think of “diversification” as synonymous with the old adage, “Don’t put all your eggs in one basket.” While the two ideas are similar, the adage (which is heavily bent toward the more defensive side of asset allocation) is only half true when it comes to the benefits of diversification. There’s a missing component, a crucial one. And that’s the ability to pursue market opportunities that are timely and emerging.
Not Just a Hedge, But an Additional Return Source
Balancing defensive diversification…
Let’s rewind and take it slowly. If you want to hedge your portfolio—that is, protect your assets from marching in a single file down the value drain when a market tumbles—then it helps to hold a wide variety of non-correlated assets. This term is just a fancy way of saying that if one asset declines, other assets either won’t decline as much, or they’ll stay the same. Even better, they could do the opposite and rise in value. That’s the defensive aspect of diversification.
…with productive diversification.
But as you hedge, you’re also opening yourself up to the possibility that a given financial instrument, asset class, industry, sector, market, or country might pull ahead of its financial “peers”—correlated or not. In other words, you are putting additional return sources in your portfolio that proverbially “scout” for new opportunities that could unfold in a market or economy. That’s the productive (or “aggressive”) aspect of diversification.
Considering the two, who wouldn’t want both value protection and value proliferation?
Start Diversifying Your Portfolio
So, what’s the ultimate goal of diversification? To set yourself up in such a way that your positive payoffs significantly outweigh your negative returns. While some assets fall as others rise, you want your rising assets’ growth rate to be more substantial than your declining assets’ rate of decline.
It’s cyclical, but one that expands your wealth gradually while reducing your overall portfolio volatility and losses.
How Many Ways Can I Diversify?
How many ways can I diversify my portfolio? The simple answer is “quite a few.” We’ll skip the more traditional approaches, as most investors already know about it. For example, if you own a tech stock (exposed to a single company’s business risk), then you hedge it by buying another tech stock but in a different tech “industry.”
Want to hedge that? Then choose stocks out of any of the other 10 sectors. Worried about holding too many stocks? Then add bonds to the mix. You can also add a vast range of commodities as well.
But perhaps you need an even higher level of diversification. Of all the directions we can go to add that next level, let’s talk a bit about foreign currencies and trading systems.
A Counterpoint of Currencies
When it comes to diversifying your portfolio, everything comes down to one factor: correlation. This refers to how one thing (in this case, an asset) is related to another.
Highly-correlated assets tend to move together: if one goes up, the other follows, and vice versa. The weaker the correlation, the weaker the similarity in market movement. Negatively-correlated assets, such as the US dollar and gold, often move in opposite directions with one going up, and the other going down.
If you are looking to diversify a portfolio of stocks, bonds, and even most commodities, you are sure to find plenty of non-correlated assets in the forex market. You just have to check the fundamental factors sustaining or driving non-correlation, and you have to choose wisely with regard to a country’s economic position and forecast.
Say you’re well-diversified in financial securities (stocks and bonds). These are dollar-denominated assets. As you know, the dollar has been sinking, eroding your money’s purchasing power. You can invest in gold, which is negatively correlated. But if you don’t want to jump into an asset that is currently at all-time-highs, then you might look across the shores to countries whose currencies are “down but not out.” Some good examples include the EUR/USD, AUD/USD, NZD/USD, or USD/CAD (short the greenback, long the loonie).
These are just four of multiple currency pairs you can choose from. The big caveat here is that you’ll have to do your fundamental homework—and a lot of it—especially if you’re looking to hold any of these currencies for the long haul (trading them for short-term game is another matter, and a completely separate article).
And what if, like most investors, you’re new to the forex market? You can always ask an investment professional. Or, you can add yet another layer of diversification, not just with currencies but with currency trading systems: “system diversification.”
System Diversification: One to Balance the Other
A trading system that focuses on a given currency pair, say, the EUR/USD, is one way to diversify any portfolio holdings that aren’t correlated with Euro exposure (like most assets held by US investors).
That’s fine. But can you diversify one EUR/USD system against another? Absolutely. Let’s imagine a long-term “trend following” system that trades (long and short) the EUR/USD. Its performance will likely differ from another Euro-based “day trading” system that seeks to profit multiple times intraday. And both systems might differ tremendously from another EUR/USD “swing trading system” that opens and closes positions over a matter of just a few days.
Get the picture? What you’re diversifying here is not the currency or market, but the “strategy.” In short, holding different strategies, even within the same currency pair, can yield completely different results—hence, a legitimate form of diversification. This, of course, works as long as the strategy is reasonable and sound; keep your profit factor and risks within your range of preference and tolerance.
The Bottom Line: Do Your Research
If your aim is to diversify your portfolio, it helps to look at all of the options available to you. This means going far beyond the traditional “go-to’s” such as stocks, bonds, and commodities.
Countries offer diverse investment opportunities, specifically their currencies. But to add that extra level of diversification, it helps to look at a palette of different trading strategies, whose varying performances can add non-correlated returns to the mix, allowing you to create a more sustainable investment portfolio and one that exponentially expands your market opportunities.