Portfolio Diversification: What Benefits Can a Forex Trader Get by Using it?
Collect as many eggs as you can, and don't put them all in one basket – a fundamental principle of a wise trader. Trading is a big road where you can face sharp turns and bumps. That's why traders should learn more about different strategies and methods to protect themselves and mitigate the risks.
This paper will discuss the importance of diversification in Forex trading, teach you how to diversify your trading portfolio, and answer some popular questions.
What Is Diversification in Forex Trading?
Diversification means an allocation of funds to various financial instruments or investment markets. The concept of diversification is essential in Forex trading. By diversifying a currency portfolio, the trader minimizes the risks of losses and provides a foundation for stability. In Forex trading, diversification relates to different trading activities: from investing in more than one currency pair to delegating portfolio management to another trader. The process of diversification aims to compensate a trader's potential losses with prospective profits.
As a rule, the diversifying portfolio includes high-risk and low-risk assets. Often, amateur traders think they will achieve big profits by only spreading their funds to various assets to avoid risks. However, it only works this way if your portfolio consists of high-risk investments. Like all the other markets, the Forex market is quite volatile. Each currency pair has its dynamic subject to different circumstances. For example, the most volatile currency pairs move more than 70-80 pips daily. These pairs are GBP/NZD, GBP/AUD, GBP/CAD, GBP/JPY, EUR/NZD, EUR/CAD, EUR/AUD, and EUR/JPY, with the average daily volatility exceeding one hundred points! At the same time, the least volatile currency pairs include Swiss Franc as a safe-haven currency. Here there are USD/CHF, EUR/CHF, AUD/CHF.
The Forex market is a multi-faceted system where you should keep your eyes open and reasonably use your trading portfolio. This is where the diversification mechanism comes in.
How to diversify your Forex trading portfolio?
Split your funds
Diversifying a trading portfolio should start with the prudent distribution of your money. In Forex, seasoned traders prefer to use the Pareto principle (80/20 rule) of funds distribution. Per Pareto, only 20% of actions cause 80% of the effects. In risk diversification, a trader invests 20% of capital in highly volatile currencies while placing the other 80% in less volatile investments or keeping them in cash. Thus, 20% of one's funds may provide 80% of the portfolio's growth or otherwise 80% of losses.
Invest in different currency pairs
As we have already mentioned, all currency pairs are individual in terms of volatility and risk levels. Some currency pairs overcome more than one hundred points in one day, while for others, it takes a whole week. In case of high and fast fluctuations of currency exchange rates, trading is more effective and profitable but tricky at the same time. To balance between probable ups and downs, we recommend you invest in at least two currency pairs where one pair is highly volatile while another is more or less stable across time. Anyway, no rush! Switching to trading with several currency pairs is appropriate when you succeed in working with one.
Change trading times
It is essential to remember that Forex is an unsleeping market that works around the clock. Daily activities in Forex are divided into four sessions: Asian, European, American, and Pacific. Such a working schedule allows participants to open and close trades day and night. Typically, traders stick to the specified working time, which sometimes needs to be corrected. Depending on the time, the currencies also behave differently. So, experimenting with trading time may open new doors for you.
Keep up-to-date with daily news
To diversify the Forex trading portfolio, traders should pay enough attention to the current world situation. Economic changes or geopolitical events may cause unexpected market movements and vitally affect your decisions.
Use different trading strategies
The mix of different trading strategies is a foundation for solid risk diversification. Learn different trading styles, and experiment with the timeframes of transactions. For example, it might be effective for the trader to transfer part of the trading assets to the management of another trader. Regardless of their experience and skills, all traders go through periods of losses and gains, so having more than one trader will reduce the volatility of your trading portfolio.
How can traders benefit from diversifying their portfolios?
The goal of diversification in currency trading is to balance your portfolio against prospective gains and losses. Diversification of the Forex trading portfolio allows the trader to mitigate the risks and survive in conditions of strong market volatility. Let's discuss in more detail some of the advantages of diversification!
Mitigated market volatility
No doubt, the diversification technique reduces the influence of market volatility on your trading practice, as some investments will provide a profit while others – losses. The diversification strategy allows traders to keep their trading portfolio in balance and withstand economic changes.
There is no secret that everybody will be devastated by losing their funds. For traders who got used to monitoring their positions every single moment, it is very important to exclude excessive emotionality. The diversification strategies, in turn, allow the traders to lower their emotions and feel more or less safe.
Diversification is an effective tool of the risk management strategy helping to minimize the impact of any one investment on the whole portfolio. Keeping many positions open at the same time can prevent a decrease in the value of your investments all at once.
The primary goal of Forex traders is to grow their funds. Thus, the diversification of your Forex trading portfolio usually entails higher profits. By investing in different currency pairs, traders increase their chances to benefit. Capital growth may happen if one currency pair suffers losses, but another compensates for this loss and increases the final gain.
Trading on multiple markets
Diversification allows you to enter various markets by investing in different currencies. These diverse investments expose traders to different economic and political systems where they can reach higher achievements.
Top tips for diversifying your Forex trading portfolio
Especially for you, we prepared several tips that will help you diversify the Forex trading portfolio.
- Before investing in a particular currency, examine the whole environment: from inflation to geopolitics in the corresponding country.
- Keep your portfolio small by investing in a limited amount of currencies because this will contribute to a more accurate analysis of the markets.
- Close the positions once you reach your goals, as trading beyond taking profit may cause losses.
- Only surpass lot sizes if you can bear probable corresponding losses.
- Stay updated on the current market situation to mitigate the risks of losses if all the currency pairs you own are in a critical position.
The benefits of diversification in Forex trading: Summary
It's like a painkiller! Diversification is an effective strategy in Forex trading that helps a trader survive in high market volatility conditions. By diversifying the investments, a trader reduces the risks of losses and improves the long-term portfolio performance. This technique can also improve your emotional stability, expand your horizons and help you to attain high achievements.
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What is diversification in trading?
Diversification is a strategy of spreading the trader's funds between different investments in order to mitigate the risks of losses and balance a trading portfolio.
Generally, there is a vast number of decent trading strategies created by different traders to help you succeed in Forex trading. However, each trader has his authentic trading style – he needs to find the best trading strategy that satisfies his preferences and risk tolerance.
What are the advantages of diversification?
By diversifying the investments, the trader reduces the risks of losses, improves the portfolio's efficiency in the long term, and increases the chances of reward.