As a trader and an investor, it’s important to understand the value of portfolio diversification to potentially mitigate risks and increase your returns. Not all your investments will perform well, as there will be times when some will underperform. To avoid facing significant losses when this happens, you should have other investments in your portfolio that are able to compensate for the loss.

Introducing the concept of diversification!

Diversification, theoretically, guarantees that your overall risk is reduced, as you don’t have all your eggs in one basket. Let’s take a closer look at how you can better diversify your trading positions to avoid being overexposed to one country, sector, or currency.

Invest in different asset classes

When managing your portfolio to reduce its risk profile, it’s important to consider spreading your investments among different classes. These ’classes’ of investment assets are generally grouped together based on having similar financial structures and rules/regulations for their governance.

There is some difference as to the exact number of asset classes and what they each contain, but as a rule of thumb we’ll explore the following six categories:

Real estate

A great option for those looking for something ’solid’ that provides some relief from inflation.

Stocks/Equities

Invest in the shares of different public limited companies being traded on the stock market, earning through capital gains and/or dividends.

Cash/Cash equivalents

A highly liquid option for easy access, typically a fund investing in cash or short-term deposits with the aim of earning a better interest rate than a standard bank account.

Bonds/Fixed Income investments

Generally considered a less risky investment, these are fixed-income investments in debt securities paid in the form of interest.

Forex

Trading international currencies like the EUR, the USD, the CHF, or the JPY.

Commodities

Precious metals, such as gold or silver, energy, such as oil or natural gas, and agricultural commodities like orange juice or coffee. 

Holding a spread of investments across these classes helps to provide a level of portfolio stability, as a downturn in one should be at least partially offset by the performance of others.

It’s also important to consider your personal risk appetite and what role your financial circumstances and age should have in your chosen allocation. For optimum results this will need reviewing throughout your investment journey as your tolerance for risk will likely change through the various stages of your life.

As a younger person, you may feel more comfortable with potentially higher-risk investments, given that you have more time to recoup potential losses. In later years and nearing retirement, however, your portfolio might lean toward a lower return but ‘safer’ allocation, such as bonds or equities, or you may even choose to hold more in cash.

Invest in different assets within an asset class

Depending on your established risk profile and personal interests, you should also choose to diversify your portfolio by investing in different assets within the same class.

For example, if your interests were predominantly in the stock market, you need to be aware that stocks can be classified into multiple categories based on various parameters, such as the size of a company, the industry, the risk, the volatility, and the dividend payments, as well as other fundamental factors.

One such method of classifying stocks is by the total value of their shares, or Market Capitalisation. Bigger companies ($10 billion or more) are generally referred to as large-caps or blue chips, with mid-caps ($2 to $10 billion) and small-caps (less than $2 billion) being worth successively less.

Typically large-cap companies are considered safer investments, but they may provide fewer returns than promising and successful small and mid-caps.

Classifying based on whether a stock is cyclical or non-cyclical is another popular method.

Countries often have times of prosperity and downturn, depending on the phase of the economic cycle. A cyclical stock could be something like the travel industry, which can be profitable in times of economic prosperity, but not so much during events such as global pandemics. A non-cyclical stock would be consumer staples goods that are always needed, regardless of economic circumstances.

A relatively simple and inexpensive method of gaining wide exposure across the different sectors and classifications would be to invest in ETFs. These funds trade similarly to normal shares and can hold a wide range of top-performing securities that can help you better diversify your investments.

Invest in domestic as well as international markets

Another way to potentially diversify your investments is through different regional or geographical areas. Theoretically, an adverse event in one country’s markets may not affect the other, as countries have different growth drivers and prospects.

Moreover, monetary policy differentials between countries might bring different opportunities to investors and traders.

You can invest in stable economies like the US for instance, or you may wish to try your luck at investing in an emerging market such as India for a chance at potential higher growth prospects – your choice will mostly depend on your risk appetite.

Investing in International markets can be made in a variety of ways and via a number of vehicles, ETFs are just one example and there are many to choose from depending on your preferences. You may choose to invest in Broad Foreign Markets ETFs, Emerging Market ETFs, International Bond ETFs, Foreign Currency ETFs, and Commodity ETFs, among others, to expose yourself to other countries.

Another great advantage to investing in other countries is to profit from currency exposure. While it can be risky if the exchange rate is not favorable for your investments, it can also play out in your favor.

Consider the dollar-cost averaging technique

Attempting to constantly ’time the market’ with large lump sum investments can be stressful, and you may run the risk of buying during a peak period. It’s worth looking at the option of dollar-cost averaging, or DCA, to spread out your investments over time, especially if you consider yourself to be fairly conservative and you tend to invest over a longer-term time horizon.

If, for instance, you inherited $10,000, and intended to invest it all in the stock market, you may want to allocate $1,000 per month on stocks you’ve pre-selected instead of the entire amount at once, so as to reduce the effects of short-term market movements.

Having a long-term and consistent fund investing strategy will help you gain access to a broad range of global markets through the DCA approach at a reduced average cost and maximize your results. So the DCA is the preferred strategy of those looking to invest for the long-term.

Rebalance your portfolio periodically

Checking in with your portfolio on a regular basis (at least once a year ideally, but whatever suits your style of investing) – to rebalance your investments is important to continue to fit with your established long-term goals and to protect against exposing your portfolio to increased risk.

It is, therefore, important to rebalance your portfolio occasionally to take into account the new macro-economic environment to better protect your investments and pick the most promising financial assets.

Still, however, you choose to maintain your portfolio and how often, balance is the key to successfully keeping risk to a tolerable level and achieving the highest possible returns whilst not sacrificing a good night’s sleep!