Why is diversification so importan for traders and investors

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Aaron Hodari – SCHECHTER

Much has been written about the strength of the U.S. markets in 2020. U.S. large-cap stocks rose 31.5%, their best year since 2020.

That’s a great year for domestic investors, but I fear it causes some to miss one of the key points of investing, which is that markets move in cycles.

Don’t believe me? Let’s look at a couple of arbitrary market periods.

In 2020, large-cap U.S. stocks returned nearly 22%. Small caps returned nearly 15%. Nobody complained about those returns. But do you know which asset had an even better year? International stocks.

Emerging market stocks—i.e. the MSCI Emerging Markets Index—returned a whopping 37.8% in 2020, while developed market international stocks—i.e. the MSCI EAFE Index (which measures the equity market performance of developed markets outside of the U.S. & Canada, essentially the global equivalent to the S&P)—returned 25.6%. These were the two best-performing asset classes of the year.

Here’s another. From 2002-2007, the S&P 500 returned 6.1% annually. The MSCI EAFE Index, returned 14.8% over that same period.

Both time periods above are, as mentioned, completely arbitrary, but they underscore an important point about global diversification. While there is no one-size-fits-all approach for everyone, having some sort of international allocation is critical to maintaining optimal performance in most long-term portfolios. This is one of the core principles of asset allocation that I try to get across to my clients.

Because of globalization, it’s become increasingly difficult, perhaps impossible, to avoid having at least some sort of international exposure in your investment portfolio today. Most U.S. large caps count international sales as a major revenue source—for example, international sales accounted for 59% of Apple’s revenue and 40% of Starbucks’ revenue in the June 2020 quarter.

But owning Apple or Starbucks and saying you’re globally diversified is inadequate. A true allocation to global assets means looking beyond U.S. companies. According to Vanguard, U.S. equities accounted for 55% of the global equity market as of September 2020, leaving the remaining 45% available for capital allocation.

This is just one reason why I reinforce international allocations to my clients.

Diversifying to global equities minimizes the likelihood that one market downturn will have an outsized effect on total portfolio performance. So when markets like the Hang Seng get punished, the damage is limited.

More importantly though, research has found that, historically, globally diversified portfolios have generally outperformed their non-diversified counterparts. According to Charles Schwab, not only did a globally diversified portfolio outperform both the S&P 500 and a conservative 60/40 U.S. stock/bond blend from Jan. 1, 2001 to Sept 30, 2020, but it also held up better during both economic recessions during that time.”

This happens because markets are cyclical. In the 1980s, international stocks crushed the U.S. That was followed by a stark reversal in the 1990s. This decade, the U.S. has dramatically outperformed the MSCI EAFE.

It may not seem like it, but the dominance of the U.S. over international stocks should eventually change, as it always has. Vanguard’s chief investment officer told CNBC last November that he expects international stocks to outperform their U.S. peers by 3-3.5% over the next 10 years, in part because of increased U.S. valuations.

Globally diversified portfolios are well-positioned to take advantage of growth over long-term time horizons—whichever market it comes from.

Volatility can eat away at returns over time, so it’s important to keep it managed in long-term portfolios. One of the ways we accomplish that is with international diversification.

A report from Vanguard found that having between a 40-50% allocation to international equities actually reduced volatility to below 15%.

“The benefit of global diversification can be shown by comparing the volatility of a global index with that of indexes focused on individual countries. While the United States had the lowest volatility of any individual country examined, its volatility was slightly higher than that of the global market index. Other countries examined had volatilities that were 15% to 100% greater than the global market index.”

The chart below shows this trend. From 1970-2020, a globally diversified portfolio had lower annualized volatility than any individual market.

International investing comes with its own kind of unique risks.

You expose yourself to, among other risks, currency volatility, political instability, and economic fluctuation. Plus international markets can be less transparent and harder to navigate than those in the U.S. This is partly why managing global allocations is an area where professionals can come in handy. Advisors with the ability to conduct research on foreign companies and rebalance portfolios based on market performances provide their clients with a unique edge.

The importance of rebalancing Portfolios, in particular, cannot be understated.

Vanguard estimates that a hypothetical traditional 60/40 U.S. portfolio created in 2020 would now more closely resemble a 70/30 split given the outperformance of stocks over bonds.

According to the 2020 Credit Suisse Global Investment Returns Yearbook, the U.S. stock market accounted for 15% of the world’s total stock market in 1989. At the start of 2020, it was 53%. These disproportionate performances cause portfolio weightings to get distorted from where they started. Having someone who can see these shifts and rebalance accordingly keeps your asset allocation and risk exposure where they should be.

The most common argument you’ll see against international diversification (such that they exist) is that correlations between the U.S. and global markets are shrinking. While this is true, it doesn’t change my view that having a strategic allocation to global assets puts portfolios in the best position to achieve long-term growth.

Aaron Hodari, CFP, CIMA, is a Managing Director of Schechter, a boutique, third-generation wealth advisory and financial services firm located in Birmingham, MI. For 80 years, Schechter has quietly advised wealthy families on complex financial matters. Today, Schechter and its affiliates, Schechter Investment Advisors and Schechter Private Capital, continue to provide our clients with institutional quality investment advisory services, access to alternative investments and specialized wealth management solutions, including advanced life insurance, income & estate tax planning, business succession, and charitable planning.

Disclaimer: The views expressed in this article are those of the author and may not necessarily reflect those of Schechter or its affiliates. There is a risk of loss in trading and investing of any kind, and the diversification strategies described herein do not ensure a profit and do not always protect against losses in declining markets. The material herein is provided for informational purposes only and should not be construed as investment advice, a specific investment recommendation, a solicitation, or an offer to buy or sell securities Investment decisions should be made based on, among other things, an individual investor’s applicable objectives, risk tolerance, and financial circumstances and in consultation with his or her advisor(s). Past performance is no guarantee of future results.

Thread: What is diversification

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What is diversification

What’s the meaning of diversification.

Diversification as with financial dealings is the way an investor tries to reduce the risks tied with financial operations and investment by sharing his capital over different businesses. This way, the risk still remains with his investment but this time it is not concentrated on one single financial operation plus it will automatically become reduced in a way or the other. This could be likened to the popular adage which says that one should not put all his eggs in a single basket. While the reward of investing into anything is not certain, sharing a capital into mulitple investment will give an investor an edge. In the case where one investment fails, the others might not fail. The profit made from the investment that generates return could then be used to cover up for the losing ones. This is a very wsie method of making investment.

Diversification : is a type of risk management in which the trader chooses mix of different investments in a portfolio in order to reduce volatility of the portfolio via using these different investments as a hedge to each others, where diversifying our investments in the portfolio can reduce the risks of facing big losses, where the profits which can be achieved from some investments in the portfolio can cover the losses that may be achieved by the other investments in the same portfolio, so the diversification is very important in any portfolio because it helps in minimizing risks and maximizing profits of a portfolio, because the diversification makes us use different sources of investments in the market and this can make our portfolio perform well even during periods of bad market conditions, but the important thing is to choose the right mix that can achieve profits to us.

Diversification the action of diversifying something or the fact of becoming more diverse. It could also be a business engaging in other fields of operation, varying its range of products. Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. Investors accept a certain level of risk, but they also need to have an exit strategy, if their investment does not generate the expected return. Diversification allows the trader to have an escape route in case the business runs into loss in one.

Diversification can be defined as an investment approach that plans to limit potential losses while increasing profits. It’s a smart risk management strategy if you ask me. It accomplishes this by spreading exposure to multiple level assets and within every asset level. The process is that if one part or one asset goes down, the whole system doesn’t follow suit, and may even bring more returns elsewhere. It’s the practical application of the saying ‘don’t put all your eggs in one basket.’ Financial experts usually advise their clients to diversify for long term businesses such as retirement plans. If you’re having a problem with which portfolio you need to diversify, you should think of consulting a financial expert which will guide you.

In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. If asset prices do not change in perfect synchrony, a diversified portfolio will have less variance than the weighted average variance of its constituent assets, and often less volatility than the least volatile of its constituents.Diversification is one of two general techniques for reducing investment risk. The other is hedging.
Return expectations while diversifying
Amount of diversification
Effect of diversification on variance
Diversification with correlated returns via an equally weighted portfolio
Diversifiable and non-diversifiable risk
An empirical example relating diversification to risk reduction

In finance, diversification is the process of allocating capital in a way that reduces the exposure to any one particular asset or risk. A common path towards diversification is to reduce risk or volatility by investing in a variety of assets. If asset prices do not change in perfect synchrony, a diversified portfolio will have less variance than the weighted average variance of its constituent assets, and often less volatility than the least volatile of its constituents.Diversification is one of two general techniques for reducing investment risk. The other is hedging.
diversification is very important part of life

Hi buddies how are you all hope you will be enjoying your day. Friends disverification is that you couldn’t verify the address and information you provided in your account you should give the information that you can verify

Diversification is extremely important for every investor in the entire financial market, this alone is not applicable to the forex trader, it’s for every investor either In the stock market, option market and the forex market etc.
Diversification of fund simply means spreading of our respective trading capital in the market, or on different asset or currency pairs. Why is it important?

There is a statement which says never put all the egg in a basket, this is just avoid loosing all the eggs at one’s of something eventually happen to the basket, so it means investing in different market or asset to give ourselves chance of becoming profitable in different places and if we loose in an area, it will always be minimal.

Time horizon and liquidity of investments is mostly a key aspect influencing threat assessment and risk control. If an investor wishes price range to be immediately on hand, they may be less possibly to invest in excessive danger investments or investments that cannot be right now liquidated and much more likely to vicinity their money in safe securities.Time horizons will also be an vital factor for character funding portfolios. more youthful investors with longer time horizons to retirement can be inclined to invest in higher risk investments with higher capacity returns. Older traders would have a specific risk tolerance given that they will want budget to be greater quite simply to be had.

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Every so often, events occur that are so earth-shaking they send reverberations to every corner of the market. Fortunately, events of this magnitude are rare. Most of the time, there tend to be different factors affecting different parts of the market. Therefore, the chances of many independent markets being adversely affected at the same time are fairly small.

Herein lies the heart of portfolio diversification theory. Diversification is all about choosing to invest in several different areas of the market, in order to reduce the risk of your overall portfolio being adversely affected by any one factor. In other words, by choosing our asset allocation wisely, we can seek to shelter ourselves from risk.

Portfolio Diversification and Risk Reduction

So, the effect of portfolio diversification on risk is to reduce it, but we should note this doesn’t apply to all types of risk. Of course, when we trade there is always some inherent risk, that’s just the nature of trading and investing, and there are limits to the effect of tactical portfolio diversification. It’s important here to qualify exactly which type of risk it is that we reduce with diversified portfolio strategies.

Systematic and Unsystematic Risk

Systematic risk is the inherent uncertainty of the entire market, and therefore cannot be mitigated by building a diversified portfolio. Unsystematic risk describes the types of risk that we can protect against, at least to some degree, by selecting a well-diversified investment portfolio. Occurrences that disproportionately affect one company, sector, or a type of instrument are examples of unsystematic risk.

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Think about a stock market investor who is building an investment portfolio. If their investment allocation is varied, then news affecting one sector will affect only some of the stocks in their portfolio. In other words, their diversified investment portfolio helps to cushion against the effect of specific bad news. Failing to have a sufficiently diversified portfolio is akin to the well-known idiom of ‘putting all your eggs in one basket’.

For example, consider an investor whose investment allocation focuses solely on energy sector stocks. If OPEC decides to increase oil output, it could depress the value of the entire portfolio. Now, consider if the investor had a cross-section of companies from a variety of sectors instead. This would ensure a portion of the portfolio was less exposed to the sudden changes in the energy sector.

Here you have the answer as to why portfolio diversification is so important. An investment diversification strategy seeks to take positions in sufficiently different instruments, so as to lower your exposure to risks tied to specific segments of the market. That being said, if you look back at the financial crisis of 2008, it wouldn’t really matter how well you had employed CFD portfolio diversification if all your positions were in equities.

This is because the systematic nature of the problem stressed all sectors of the market. Share prices as a whole moved sharply lower, along with other types of investments, such as house prices. Events such as war, interest rate changes, and economic slumps tend to affect the whole market, and can’t really be protected against via tactical asset allocation. The main strategy for protecting against this type of risk is hedging.

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Why is It Important to Diversify Your Investment Portfolio?

Diversification is important in investing because it reduces the chance of an adverse factor affecting the whole of your portfolio. Trading profitably is all about winning in the long run. You cannot win in the long run if you experience a drawdown severe enough to prevent you from trading. Diversification helps to avoid this negative scenario. Is there an advantage of portfolio diversification beyond just trying to diminish risk though? The answer is yes.

Here are the three benefits of portfolio diversification:

  • It reduces risks tied to specific assets classes
  • It increases the chances of encountering conditions favourable to your system
  • It delivers more signals

Let’s consider a trader who only looks at a narrow set of currency pairs. Let’s suppose that they are a trend-follower who only considers trading with the EUR/USD and GBP/USD FX pairs. If these currency pairs are range bound for an extended period, the trader isn’t going to have any signals to trade on. Now consider the trader who looks at a diverse range of markets. This trader is likely to receive more entry signals.

But beyond that, trend following is all about locating a big winning trade amongst more frequent, smaller losing ones. By exposing themselves to more markets, our trader has increased the chances of encountering the favourable market conditions required for a big winning trade. In this case, they have widened the odds of finding a persistent trend.

Multi-Asset Diversification

If you’re aiming to hold a number of financial instruments, the same principles of risk-balanced portfolio construction apply. So if you’re a commodity trader, you’ll be wise to consider some kind of commodity diversification. Of course, proper portfolio diversification also involves spreading your risk across multiple asset classes.

If you hold diversified financial investments, you are less likely to be overly exposed to one risk area. This means that with the right kind of tactical investing, you can achieve some simple reduction in overall risk. So how do you decide your portfolio allocation? As is usually the case with trading, the question really depends on the individual. What are you trying to achieve? If you are risk averse, portfolio diversification will be a big issue for you.

Diversified Portfolio Example

With a stock portfolio, it is quite easy to construct a diverse selection, where you can mix and match from different sectors. When it comes to Forex portfolio diversification, it can seem less straightforward. Generally speaking though, what we are trying to avoid is this: trading in the same direction on a number of currency pairs that are correlated.

If we can do this, then we have gone some way toward achieving a more balanced investment portfolio. So, how can we tell which Forex pairs are correlated? Here’s where MetaTrader Supreme Edition for MetaTrader 4 and MetaTrader 5 is really handy. The MTSE plugin offers you a greatly enhanced suite of trading indicators and trading tools. Among these tools is the correlation matrix.

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The correlation matrix allows you to see at a glance the strength of correlation between currency pairs. It also allows you to view the correlation in different time frames. Here are some simple tips for a portfolio diversification strategy:

  • Check correlation in multiple time frames
  • Avoid trading in the same direction on strongly-correlated pairs
  • Alternatively, actively trade in the opposite direction to strongly-correlated pairs
  • Avoid similar positions involving currencies from the same regions
  • Diversify further by holding positions over different time frames
  • Also, consider diversifying your strategy style

Overall, the idea is to strip out commonalities between different positions within a portfolio. For example, if you were considering going long on AUD/GBP and NZD/USD, you might only choose one of the two in the interests of diversification. This is because NZD and AUD are both currencies from the Oceania region. We might reasonably expect them to be similarly affected by factors specific to that region.

The final point in the list above refers to the actual trading strategy you are using. You might find that a certain strategy only offers a few signals per month, while another offers 20 or 30. Dividing up your available risk capital amongst these strategies might help to complement each other. An excellent way to practice these techniques and work out what is the right mix for you is with our risk-free demo trading account. This way, you can try out your strategies first, and see what works best before you attempt trading with your capital at risk in the live markets.

A Final Word on Portfolio Diversification

We’ve looked at the basics of diversification, just one of a number of foreign exchange risk management strategies. You can very easily take these ideas and tweak them further so as to achieve greater Forex portfolio optimization. Remember that investment diversification is not a guarantee against loss, but it can be considered a broad safety net to help cushion against residual risk. Also, remember that the objectives of portfolio diversification are to protect the sum of the whole.

So even if you have diversified investments, individual segments of that portfolio are still going to be at risk. This is why it always makes sense to utilise other good Forex risk management strategies with every individual trade. Consider using stops, together with money management. Finally, you should never diversify into areas that you don’t understand. There is an argument to be made for keeping your focus within your area of specialty, so don’t feel obliged to diversify for the sake of it.

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Tackling Risk With Portfolio Diversification

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Admiral Markets is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world’s most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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