Whether you trade stocks, Forex or options an important part of reducing risk is diversification in investing. Putting all your money on one horse is high risk and is the sign of a gambler, not an investor. No technical analysis or momentum prediction is 100% foolproof and ever investor must reckon with periodic drawdowns.
Diversification in Investing – 3 factors to consider.
It helps to break the topic up into different questions that you consider separately before bringing them together for the final investment decision.
- Risk and reward
- Exposure diversification
- Portfolio rebalancing
Risk and Reward
Every investment vehicle or strategy has a distinct risk profile, and you need to be aware of this. Similarly, each approach has a potential reward profile. In most circumstances the reward is directly proportional to the risk. This means that the more profit you hope to make, the more risk you must be willing to handle. A good investor tries to balance this out.
For example, trading ETFs is low risk, but the return on investment (ROI) is barely higher than the inflation rate. Trading DITM (Deep-in-the-Money) options can increase the reward without increasing the risk. Buy-and-hold stock trading (for a stock with good fundamentals) can be profitable, especially if you reinvest dividends. Selling covered calls on your stock portfolio can increase your ROI without increasing risk. Buying calls options is highly risky unless you are an accomplished swing trader, but the rewards are amazing. Selling option spreads is slightly less profitable in the long run, but the risk profile is even lower than buy-and-hold strategies.
The market has different sectors and each sector has different cyclical growth or retreat patterns. Your investment plan should include stocks or options from each sector. As money flows from one sector to another, you can track this and plan your investments accordingly. You should never have more than 2-3% of your portfolio committed to a particular stock and never have more than 20% designated to a certain sector.
Every year or every quarter, you need to look at how well your portfolio is balanced. In a given time period, some sectors will grow while other remain static or shrink. This can leave your portfolio unbalanced. As a responsible investor, you need to rebalance your diversification in investing. So, perhaps you have divided your portfolio evenly between Forex, ETFs, REITs, options selling and favourite stocks to buy-and-hold. If you experience bold profits by selling options, you can take these profits and reinvest them in the other sectors so that the proportion remains the same.
The learning curve
It is easier, but riskier, to stick with one investment strategy. It is well worth it to invest educational effort into diverse strategies. This can be one of the biggest factors in reducing your risk profile. Serious investors, who have no wish to gamble, will make this investment. Diversification in investing is one the most powerful profit factors, simply because it stops you losing money.