Diversification: protecting capital from market predators

An old market saying states: “One cannot outrun the risk but one can diversify it”. The bottom line is that critically high financial risk should be taken as a distinct enemy, and the fighting strategy should be developed prior the first deposit replenishment and opening of the first deal.

Your capital should not be bound to one asset, market, strategy, timeframe or broker — it kills your freedom of action. We will remind to our reader about the general types of diversification which are applicable to trading.

So let’s begin.

Risk diversification: what kind of beast is it?

From the stock operations perspective, diversification (from Latin diversus — different, facere — do) is a distribution of assets and capitals by different kinds of investments for minimization and mutual compensation of potential losses (see Diversification (finance).

The wide interpretation of the notion includes operations on all kinds of financial markets, assets, methodologies. A package of various tools is commonly referred to as an investment portfolio.

The goal of this process is simple: to secure an investor from the complete loss of money as a result of unforeseeable events, as well as to provide, if not the highest, then at least stable income.

Investing in unrelated assets and methodologies which have different reliability, liquidity and profitability is considered optimal. This allows us to increase the probability of income with minimum losses.

However, incomprehension in the math of the process leads to so-called naive diversification: a beginner thinks that it is needed to just scatter the capital over different ‘bins’ without any relation to risks and profitability. However, if all or most of assets are too risky — such approach has absolutely no sense.

Let’s look in detail how this process is implemented.

Diversification by the kind of assets

It is a traditional, the most comprehensible and, as history shows, the most effective method of risk optimization. Today even a small investor has access to the currency, stock, and commodity market. Both mid-market diversification and investment into several assets of the same kind are suggested.

Fans of over-the-counter investments combine the acquisition of stocks for a short term with purchasing the obligations for a longer term: debt instruments usually pay percent during a recession, stocks get depreciated faster, but give a bigger profit under the economic growth.

Every instrument, traded inside such a scheme, must be dynamic and predictable. If one asset makes a loss, it must be compensated by a profit from other instruments. Mid-market diversification of risks allows one to earn while one market is ‘sleeping’ and another one is being activated.

The general rule: assets must be significantly different. If, for example, buy a 6E contract (currency future for the euro) and open a spot deal for EUR/USD, then we get trading with practically the same asset — with the same dynamics and risk, that is there will be no risk insurance.

Experience shows that using the correlation between assets at the modern, too predictable market is ineffective from the diversification point of view. There are, of course, other options of complex deals, for example, trading spreads, but this is a separate, more serious topic.

Diversification by risk level

With availability of an effective strategy, the financial market admits the pressure on aggressive, moderate, and conservative trading. The first option suggests receiving a profit for increasing pressure on the deposit, but with that, the correction of even the local trend may lead to the loss of invested funds.

Conservative trading will allow a trader to earn, and the level of the maximum drawdown will not exceed 10% of all the capital.

Receiving a profit on the level of 10-15% per month with maximum drawdown of 30% is considered a moderate (average) risk. Such a money management logic is usually called the method of full capital.

Diversification of risks by trading systems

Everything is simple: you apply a few trading strategies on one asset, each with a different analysis method, timeframe (M15-H1-D1-W1), criterion for entry points, conditions for Take Profit / Stop Loss, risk level and other trading parameters.

This way, you combine a steady and profitable long-term position with risky short-term operations, and then the distribution of finances between them shortens the overall mid-term risk from an unsuccessful combination of market conditions.

Diversification of risks by brokers

Cooperation with multiple brokers can be allowed under trading with different kinds of assets and on different platforms if it is profitable for the overall result. But equally high requirements for the technical provision of services, financial and legal guarantees are subjected to every potential partner.

Try to avoid non-transparent, related, mutually affiliated companies, for example, proportionally distribute funds between national and European brokers. We remind: in case of working with American companies, you should be ready to stricter control from the side of the regulator.

Transit diversification

Modern (and well-timed!) method: funds are invested into investment projects with various options for money withdrawal from the system — settlement account, bank card, e-wallets. In this way, mobility of your money increases and dependence on the certain nation represented by fiscal and other supervisory authorities decreases.

Trust management

The option of attracting professionals to work with your capital is a normal thing but only with a strict selection of candidates and no less strict control (we will talk separately about the selection of investment manager).

You may work by straight agreements with a trader or by the scheme of PAMM and LAMM accounts. What this means is we divide the capital for 2-3 managers with different strategies and risk level in a way that overall drawdown won’t lead to the loss of the critical sum.

You should be careful investing in PAMM-projects too “promoted” by ads, as the rating of managers is not always meets the reality.

Excessive diversification or why much is not profitable

A bunch of assets in one portfolio is not a sign of management quality, unless you are an investor of Berkshire Hathaway level. Excessive spraying of funds over all influencing factors (see above) leads to a trader (or an investor) losing control both over the process and the result. As they say, ‘miss the forest for the trees’.

What’s the result? Trade time is spent on pointless doubts, and the need to follow the plenty of indicators distracts you from the real market analysis.

Diversification process is somewhat similar to confectionary recipe in which it is recommended to add 10 grams of salt and 300 grams of sugar into the dough. Without salt — the taste of a meal will not suffer; forgot to put sugar — throw the result in a trash can.

So what’s the problem?

Choose as many factors (assets, markets, strategies etc.) as you will be able to track equally adequately — by time, personal physical condition, availability of necessary information.

Start with two or three factors, the most comprehended by you personally and the less dangerous from the risk point of view. Alongside, it is possible to test the profitability of additional elements and add them to the system.

Several practical remarks

While your understanding of a certain trade asset is quite foggy, it shouldn’t be used as a diversification instrument.

Until you master general diversification principles, use the simplest formula for the risk insurance: define the minimum trading sum on the deposit, and regularly monetize a profit or withdraw it to another trade account.

Keep in mind: with diversification over multiple brokers, you will have to control the situation on a few (often different) terminals, which significantly increases some risks — both technical and psychological.

Diversification as a capital management system decreases both a risk and a potential profit, which gives market amateurs the main reason for criticism, but after wasting the deposit, most of it can be heard no more.

From personal experience, we would like to tell the following: right distribution of financial and trading pressure over assets will be, most likely, the most difficult and important decision that you will have to take. Moreover, the diversification scheme needs a regular correction towards the current market.

Accustom yourself to use each dollar of your capital, and then you will definitely understand how, when and how effectively it works (for the curious one, see a great video on the topic — John Jagerson: Diversification in the Forex).

We remind: the main goal of your presence on the trading market is a constant and stable profit, so create your formula of risk diversification, and you will be a winner.

Try It Yourself

In order to try these money management tips or other ones, no need to risk at youк live Forex account. Simply download Forex Tester for free. In addition, you will receive 23 years of free historical data (easily downloadable straight from the software).

This way you can spend as much time as you need to sharpen your money management skills and grow your confidence as a professional trader.