What does diversification mean and what is it for when it comes to financial markets? Today, we are going to dissect this topic and provide you with the tools that will help to not only preserve the deposit but also boost your profits.
If investing is something you are interested in, you have most likely come across this expression. In essence, diversification is the allocation of funds between different assets. The golden rule that clearly explains how diversification works is “don’t put all your eggs in one basket.”
It should be noted that diversification was mentioned back in the ancient times.
The son of David and the greatest king of Israel, Salmon once said,
“Divide your means seven ways, or even eight, for you do not know what disaster may happen on earth.”
No wonder that he was considered the wisest and richest man on earth.
Traders and investors can protect their money by means of risk diversification. To make winning trades, you obviously need to be able to accurately analyze the market, learn the ins and outs of the trading instrument, and its price change prospects. The better you know the asset you trade, the higher the odds of making the right trading decision.
That being said, there is still a great deal of risk when it comes to any investing, including investments made in financial markets. This happens because there are factors beyond our control such as crises, natural disasters, verbal or real interventions, and market manipulations by big players. Plus, there is always a chance of making a mistake because nobody can be right all the time. If you invest all your money in one financial instrument and one of the aforementioned scenarios takes place, you can lose everything you have.
In such cases, diversification is what comes to the rescue, helping to keep the risks to a minimum and avoid these dangerous situations.
If you are a trader, you can mitigate the losses by diversifying the trading portfolio. If you are someone who is using the TIMA account or long-term investment strategies, what you can do is diversify your investment portfolio. Let's take a closer look at both these risk diversification options.
Those who trade in financial markets tend to pick their favorite instrument and trade it only. This is not entirely wrong since you cannot do a proper market analysis and forecast if you do not understand the traded asset well. But it is also extremely risky.
To protect yourself from risk, make sure to choose several instruments you like. First of all, it will provide you with a greater number of entry points and better trading opportunities. Second of all, it will help reduce the number of mistakes. With one asset, there is a 50% chance of making a mistake but it can be reduced significantly when you have five trading instruments.
Another risk diversification method is to distribute your trading portfolio between different types of financial markets. You can increase your chances of making a profit considerably if you do not trade just major currency pairs that heavily depend on the U.S. dollar, but also CFDs on raw materials, securities, indices or ETFs.
Take a look at the charts of trading instruments originating from different types of markets, and you will see that their dynamics in the same economic situation is very different. This means that you can diversify the risk.
By answering the question “What is diversification?”, we have established that this method is one of the cornerstones of investing. Medium and long-term trading strategies are essentially an act of investment. As compared to intraday trading, traders invest less time and effort here.
When using medium-term strategies, it is advised to apply risk diversification. Basically, what you do is build a portfolio of stocks issued by the companies that belong to different sectors of the economy and depend on various factors. E.g. During the global quarantine and the crisis caused by the coronavirus pandemic, the stocks of the airline companies plummeted, whereas the technology and food sector stocks went up.
By having a well-diversified portfolio, you can not only protect yourself against losses, but also overcome the crisis with profit in your pocket.
Aside from diversification, another protection strategy that is hedging. For example, if the stocks included in the S&P 500 index form the basis of your investment portfolio and you bet on their growth, you can protect yourself with a pending order for this index’s futures. If your key position gets closed at a stop loss, the profit made in the hedging trade will exceed the loss.
But what about the investors who don’t not trade themselves, but the managers do that for them? How can they diversify the risks?
The answer is simple - TIMA accounts. This solution allows investing in several strategies, not just one. With this diversification method, you can earn solid profits and mitigate the risk of capital drawdown.
If you wish to use the risk diversification method in trust management, you can pick several managing traders from the TIMA Account Ranking based on their performance and distribute your capital between them. That way, you’ll be able to make a profit under any circumstances with no sweat.