Today we’ll talk about ways to protect your account balance from losing trades. No, no, we won’t be giving you some magic strategy that will generate income in a blink of an eye without a single losing trade. We’ll be explaining how diversification may help you reduce your financial risks.
What is diversification?
Now, let’s define the term first. Diversification is simply the distribution of investor capital between various accounts and asset classes. It implies creating a mix of trading instruments in your portfolio to limit the exposure of your trading account to risk if the market goes against you in one of your trades.
Why you need diversification
First of all, a trader should understand that in any market, be it the Forex market of the stock market, there are forces that cannot be controlled. No one can predict with a 100% accuracy where the price may go. Therefore, it is vital to diversify your portfolio. Making a profit from various sources gives you a great advantage.
As simple as it sounds, many traders fail to diversify their portfolios correctly, which sadly results in full or partial loss of their funds and assets. It is important not only to allocate your capital among multiple trading accounts or asset classes. The most effective diversification is using various strategies and approaches in your trading.
- Let’s consider several examples of diversification. Let’s start with the simplest way – entrusting part of your funds to a professional asset manager. This does not mean that another trader is more successful in trading than you. Regardless of their knowledge and experience, all market participants win some trades and lose others. Therefore when your funds are managed by more than one trader, it allows you to reduce big drawdowns and unfavorable changes in your trading account balance.
- And here is another example of diversification. This time it’s related to investments. If we are talking about the stock market, we suggest choosing several companies operating in entirely different industries, companies that are in no way correlated with each other.
- For example, you can pick one company from the IT sector, another company may be providing e-commerce services, and a third would be some pharmaceutical company. Such distribution of your investments ensures that your account balance is always positive. A couple of months ago, when the coronavirus was just beginning to spread around the world, it caused a massive collapse in the stock market. There was no single company whose stocks wouldn’t plunge. But, some corporations showed a quick recovery after this crash, while for others it took 3-4 months to return to their pre-crisis levels. Thus, your investment loss in the oil and gas sector could be offset by lucrative investments in the IT sector.
- The third way of diversification involves trading assets with different correlation coefficients. Correlation in the finance industry measures the degree to which two assets or securities move in relation to each other. The correlation coefficient value must fall from “-1” to “1”. It is important for a trader to use the instruments where the correlation coefficient is at 0. In this case, the assets are not connected in any way. The “-1” value refers to the situation when the instruments move in opposite directions, while positive correlation indicates the relationship between the assets. That is, the instruments move in the same direction and including both of them in your investment portfolio will not help you achieve the desired risk reduction.