Over the years the most popular advice given to anyone getting into trading or investing can be epitomized in a single word: Diversify. Odds are at some point or other you’ve come across advice that says the same – but most of the time it tends to leave out the important bit, i.e. how diversification can help when you’re trading or investing.
“What is Diversification?”
The first thing you need to know is that diversification really is as simple as it sounds. It essentially is the idea that rather than trading or investing in a single entity – you spread around your available capital and trade or invest in multiple different areas.
Things become a little bit more involved when you think about the degree to which you are diversifying your investments or trades. For example, instead of solely dumping all your money into a commodity such as gold, you may want to spread it across 5 different commodities. While that would be a bit more diverse, it wouldn’t be as diverse as if you were to spread it across 5 different types of trades that include some commodities, some equities, and possibly even other financial instruments.
Advantages of Diversification
The reason why it is important to think about the degree to which you are diversifying your investment or trades is because it ties into the advantages of diversification. The main advantage being that it will reduce the overall risk that your portfolio is exposed to.
Imagine if you were to invest all your capital in a particular stock – such as a train company. If railway workers went on strike and the stock plummeted, your investment (which encompasses your whole portfolio) would take a huge hit. On the other hand if you had a more diverse portfolio than a single event like that would still have an impact – but only on one of your investments.
The same applies to trading as well. Going by the previous example with equities and commodities – if you were invested in gold or some other commodities and commodities in general fell, your equities would remain relatively unscathed. In some cases the equities may even appreciate in value. In any case, you wouldn’t face as devastating a loss – because of diversification.
As a rule of thumb the more diverse your portfolio, the less risk it will be exposed to. To be absolutely clear that doesn’t mean that you are guaranteed to never make a loss, but rather than your chances of losing a considerable amount of your capital will be dramatically lower. For short-term traders diversification is often used to ‘hedge’ bets on certain positions too, to reduce the overall losses if a certain event doesn’t pan out the way you may have predicted.
“When to Diversify?”
One of the big mistakes that new investors and traders often make is that they feel that they’re still too ‘small’ to think about diversification. While it is true that if you’re starting with a really small investment you may not want to diversify across ten different entities – it is something you should work towards, right from the start.
Even if initially you are trading or investing in a single entity – when you do start to make a profit and grow your investments, your next one should be in something that moves you in a diverse direction. That way as your investments start to grow, the diversity of your portfolio will begin to expand as well.
In other words, don’t think of diversification as a something that you need to do all at once. Instead, view it as something that you can build towards at your own pace and however you feel comfortable.
“How Much is Too Much?”
It should be noted that while diversification is good – over-diversification can be damaging and diminish your returns. Assuming you’re only trading or investing in ten or less entities this shouldn’t really be an issue, but it is worth keeping in mind.
When you do reach the stage where your portfolio has grown to be that large, you will want to look into how you mix the types assets that you invest or trade in so that you can optimize your returns. Diversification will still be important, it is just the manner in which you perform it that will differ.
For now if you’re looking to get started trading or investing then you should be sure to head over to ETX Capital. By using their platform you can make trades across numerous different markets including equities, commodities, indices, and other financial instruments. With access to that many markets, you should also be able to diversify your approach and pick and choose the trades you want to make so that you can achieve the best possible returns.