Did you ever have your Grandmother tell you not to put all of your eggs in one basket?
Well it turns out Grandma was right! Grandma knew a great deal about the power of diversification and how it reduces risk in different aspects of your life, and we can relate that directly to trading and investing.
It just doesn’t make sense to trade only one market. There’s just too much risk and too little opportunity. A trader needs to stay flexible, and at the same time be diversified. Before we get into the meat and potatoes of market diversification, let's take a look at how the dictionary defines "diversification."
The Definition Of Diversification
1. the act or process of diversifying; state of being diversified
2. the act or practice of manufacturing a variety of products, investing in a variety of securities, selling a variety of merchandise, etc., so that a failure in or an economic slump affecting one of them will not be disastrous.
Based on the Random House Unabridged Dictionary, © Random House, Inc.
That's the official version of diversification. Now let's apply that to the markets. First off, we have to accept that the market can do only three things it can go up, it can go down, and it can go sideways.
Your portfolio on the other hand, can only move two ways: It can go up, or it can go down.
We all know the direction our portfolio should go, and we want to see it go in that direction with the smallest amount of risk. That's where diversification comes in. When you apply market diversification to your portfolio, you want to spread the risk and trade in non correlating assets.
An Example Of A Non-Diversified Portfolio
Let's say you are bullish on Crude Oil and looking to buy a futures contract, but the rest of your portfolio is full of energy stocks. You have created one basket of eggs. In this case, a basket of energy eggs. Your portfolio is dependent on one sector: energy. This is just too risky for the average investor. No matter how many stories you hear from the various experts saying that energy is going through the roof, you don't want to bet the farm on one market ever.
An Example Of A Well Diversified Portfolio
You need to have as many non-correlating asset classes as you can follow. You are invested in stocks, bonds, futures, and cash. Out of those four asset classes, you have a multitude of choices. Stocks allow you to cover a broad spectrum of different domestic and international sectors. Bonds do the same thing, and the futures markets cover everything from raw commodities to financial instruments. You can divide your portfolio into different percentages and allocate money to various asset classes. The more you divide into non-correlated assets, the less your risk will be.
Don't Forget About Cash
"I'm more concerned about the return of my money than with the return on my money." The American humorist, Will Rogers (1879–1935), had a special way of making a point. Don't let plain old fashioned greed get in the way. Don't forget the other key to diversification is cash! You don’t have to be in all the markets everyday. Cash is a way to diversify, Swiss Francs, Canadian Dollars, Euros, etc.
"Don't gamble, take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don't buy it". — Will Rogers
Will was right! Only buy sectors when they are going up. When they turn down, get out and move into cash. Then look for another non-correlating market sector for your portfolio that's moving up. For sophisticated traders, you can even short different asset classes to turbo charge your returns.
It takes time to analyze the markets and find winners, but I believe the time of a buy-and-hold strategy is gone forever. We are living in extraordinary times, never before have we had so many people living on the planet. Never before have we had so many major countries competing for an ever shrinking supply of raw commodities. Never before have we seen times like this that present both great opportunity and great risk.
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