Diversifying your investments should be a rule for all investors, although this theory is not accepted by all experts. The Nobel Prize for Economics in 1990, Harry Markowitz, developed the concept of diversification, which still has a large following today. Instead Warren Buffet, one of the world’s largest investors, said:
So for an expert investor like him the concept of diversification is counterproductive, but for all the others diversification can be really useful in order not to lose the capital should the investment fail.
What does it mean to diversify your investments? And why is it so important in safeguarding your capital?
What does it mean to diversify your investments?
Diversifying in finance basically means investing in different unrelated financial products. In fact, according to the Nobel prize winner Markowitz, it is wrong to invest one’s money on a limited number of stocks of the same sector, such as for example the technological or the luxury or the oil ones. The same applies to the exaggerated exposure to stocks belonging to the same stock exchange.
Investors often run into the error of having many stocks listed on the same stock exchange or belonging to the same sector in their portfolio. The performance of these stocks could be similar and therefore very risky for the investor. Diversification instead leads the trader to invest his savings in different financial products in order to decrease the risk of drawdown. It consists in the loss of the capital invested due to the negative performance of one or more financial instruments.
For example, on 5 different financial products, the negative performance of 1 or 2 of them should not compromise your capital, because it will be compensated by the positive performance of the other 3. Clearly, safety does not exist and, even by diversifying your investments, it is possible to suffer a loss, but the risk is definitely lower.
How to diversify your investments?
To understand how to diversify your investments, you need to have clear in mind what the correlations are between the various financial assets. However, let us start by saying that correlations may change over time and that there is not a real rule, but trends, and it would be good to avoid investing in financial products related to each other.
Usually the stock market is inversely related to government bonds. The shares, however, follow a similar trend in the real estate market because the acceleration of the latter is a symptom of economic growth, which helps the stock market rise.
Between the currency and commodities markets, we note the strong inverse correlation between gold and the dollar. Being the yellow metal traded directly in the US currency it would not be wise to have open operations on these two assets. In fact, if a trader had opened for example a long position on USD / JPY (US dollar / Japanese yen) and a short on the gold future, he could risk the drawdown.
On the one hand there could be the possibility of a large return if the dollar appreciated, on the other the portfolio could risk the default should the American currency depreciate.
In addition to not only owning stocks belonging to the same sector and the same stock exchange, the trader should also diversify into Forex. It is not recommended to have long positions only on EUR / USD, EUR / JPY, EUR / AUD or EUR / CHF, but it would be better to keep only one if the single European currency is expected to rise. Diversifying in this case means, for example, opening a position on EUR / USD and then evaluating others for example on GBP / JPY, AUD / CHF and so on.
The best way to diversify their portfolio is for many analysts to have investments in stocks (trying not to insist on the same sector), in medium and long-term bonds and in commodities.
If you want to diversify passively, ETFs could be an excellent financial instrument, because they have a diversified portfolio of stocks.
Diversifying on eToro with copy trading
In addition to the traditional methods, on eToro it is possible to diversify your portfolio also thanks to social trading.
Diversifying your investments with this function is slightly different from the traditional diversification we have talked about so far. In fact, it is necessary to evaluate the activities of other traders, since we are dealing with copy trading.
First of all, let’s explain that with copy trading you can replicate the operations of another trader and, therefore, you must carefully choose which of these is suitable for you.
It is not so easy because on eToro there are many professional traders with high performances, but it is necessary to choose the one who has a trading style similar to yours. It is therefore necessary to consider the time-frame of their investments, but also which assets they usually prefer.
We recommend to study the way in which the trader manages his portfolio, trying to reduce the risks as much as possible.
Diversifying on IQ Option
On the IQ Option trading platform it is possible to invest in various assets such as Forex currencies, commodities, the stock market and binary options. Here too, diversification is very important in order to reduce the risk of drawdown. For novice traders there is a demo version that allows them to be able to operate without risk on the markets.
The broker offers this possibility for free, for you to practice before switching to the real account version. If you want to start immediately with the latter, you can do it with a minimum deposit of only € 10, but remember always to diversify your investments.