Diversification in Trading – Essence, Advantages, and Disadvantages

Diversification contributes to income stabilization, risk smoothing, and a reduction in the overall portfolio drawdown. Even if one strategy proves ineffective or a crisis occurs in a specific industry, you will still have other sources of income.

What is asset diversification in trading?

In the classic sense, asset diversification is trading securities from different industries or with varying degrees of correlation with the stock market. Many successful traders fill their portfolios with securities of different classes. On commodity exchanges, futures and options trading is successfully applied in different seasons. There is also an option to trade on different timeframes or markets. It should be noted that situational traders prefer trading on a non-correlated market, while algorithmic traders prefer different ones. Whatever style you personally use, base it on a variety of methods and tools.

What is the purpose of portfolio asset diversification?

Portfolio asset diversification serves to smooth out risks and stabilize income. When composing it, securities that correlate little with each other are selected. As a result:

• When the profitability of some assets decreases, others increase
• The overall portfolio drawdown decreases
• You maintain a stable position

This also helps when using different strategies. The negative consequences of each will be smoothed out. A trader using only one strategy may lose everything if it proves ineffective.

Diversification in Trading: Where to Start?

Diversification in trading involves selecting strategic and tactical actions, securities, and deriving their correlation coefficient with each other. Excel or other programs can be used for calculations. You will get an accurate result, but the calculations may take a long time, as you need to assess the dependence of one system on all the others separately. To speed up the process, you can build a balance curve and measure the ratio of maximum profit to the allowable drawdown. You need to achieve a reduction in losses with an equivalent profit size. You can:

• Change strategy parameters
• Use other strategies without changing methods (different approaches when following a trend)
• Change methods (trade counter-trend or use a return to the average)
• Change timeframes, evaluate different charts (hourly and daily)
• Trade on different markets (currency, energy, raw materials)

Diversification in Trading: Disadvantages of its Application

Like any approach, portfolio asset diversification has drawbacks. First, to use it, you need to have significant funds. With a budget of $5000 or less, its implementation becomes difficult. Moreover, the overall trading performance decreases. A trader using only one strategy, a type of securities, and a limited number of tools has the opportunity to earn more if the goal is successfully achieved. However, in negative conditions, using diversification will protect against deposit loss. Nevertheless, it is not a panacea. In the event of a global crisis, all sectors and markets are highly correlated with each other, and many investments are at risk. The stock market offers many opportunities, but not a single guarantee. Therefore, assess your financial capabilities and risk tolerance in advance. Use available risk reduction methods.

Advice

Diversification is not just about spreading investments across various assets. It’s about understanding the correlation between these assets and how they can work together to reduce risk. While diversification can help mitigate losses, it’s essential to remember that it doesn’t guarantee profits or protect against all losses. Regularly reviewing and adjusting your portfolio to align with your investment goals is crucial.