Trading Diversification Strategies – Spreading Risk Across Multiple Assets

Trading Diversification Strategies – Spreading Risk Across Multiple Assets

February 9, 2024 0 By Ellice Whyte

Diversification allows traders to effectively manage risk and meet their financial goals. Diversifying involves investing in multiple categories, including stocks, bonds, cash alternatives and non-traditional assets such as cryptocurrency or art.

These asset classes exhibit different risk and return characteristics, so selecting a portfolio that aligns with both your time horizon and risk tolerance is key to creating the optimal investment strategy.

1. Sector Diversification

Diversification’s primary purpose is to manage risk. By spreading your investments among multiple asset classes, industries, company sizes, and bond issuers, diversification helps lessen market shocks that impact all investments evenly.

Sector diversification is a strategy used by investors who wish to reduce industry-specific risk by owning investments across different sectors – for instance technology or financial services companies – such as technology or financial services. It’s often utilized by those with knowledge about specific companies or who possess an investing thesis or time horizon in mind.

Sector diversification may not be an infallible way of protecting against all risks, but it can reduce their damage from directly related events like COVID-19 or recessions. For instance, falling oil prices would likely hurt multiple energy stock companies but have less of an effect on digital streaming companies or airlines that depend on consumer needs for transportation or entertainment services. Furthermore, diversifying across maturities of bonds may help lower overall bond correlation and lessen any impact caused by rising interest rates on your portfolio.

2. International Diversification

If an investor wanted to diversify their portfolio with Japanese equities, Australian bonds, and cotton futures – for instance by investing in ETFs like iShares MSCI Japan ETF, Vanguard Australia Bond Index ETF, or iPath Bloomberg Cotton Subindex Total Return ETN – then these investments would provide true diversification within their investment while mitigating risk when countries experience economic crises.

Due to behavioral biases like recency bias and confusion of familiar with safe investments, recent market trends have given international diversification an unfavorable reputation. Yet economic theory and history prove its worthiness as a prudent strategy.

Asness, Ilmanen and Villalon’s 2023 Journal of Portfolio Management paper demonstrated that U.S. equity outperformance versus its global peers since 1990 has mainly been driven by widerning relative valuations, not an argument to abandon global exposure altogether today.

3. Bond Diversification

A well-diversified portfolio combines various asset classes such as stocks, bonds and cash or cash equivalents to form an investment mix. Furthermore, investors diversify within each asset class by purchasing investments from various sized companies, sectors and geographical regions – and sometimes with different terms and credit ratings as well.

Diversification can assist investors in maintaining a long-term investment strategy during times of volatile markets by mitigating volatility. Spreading investments across various assets may lessen or even prevent one negative market event from having such a devastating effect.

Investors should regularly evaluate and adjust their investment portfolio as needed to ensure it reflects their risk tolerance and investment horizon. Doing this will help ensure their asset allocation matches up with what suits them best.

4. Commodity Diversification

Commodities – such as gold, oil and agriculture – should make up a significant proportion of any investment portfolio. Unlike stocks and bonds which react similarly to market fluctuations, commodities provide diversification within an overall portfolio.

Commodity investments may come in various forms: direct ownership of physical goods, futures contracts or shares in oil and gas companies that extract and produce these materials. But oftentimes it’s easier to gain exposure through exchange-traded funds (ETFs), which simplify the process and have lower fees.

Diversification can reduce the risk of large losses while not providing complete immunity from market volatility and correlation shifts. That is why investors should create a long-term investing plan tailored to their goals, risk tolerance and unique needs in order to create a balanced portfolio with diversification that meets them all.