Why diversification is the best way of tackling risk in trading

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The concept of diversification is widely used in financial trading, as this is a technique that reduces risk by allocating investments amongst an array of instruments and asset classes. Whilst this won’t necessarily mitigate undiversifiable risks (such as geopolitical instability or inflation rates), it does tackle diversifiable risks that pertain to the asset in hand.

Whilst diversification strategies are usually applied across numerous markets, it’s also possible to diversify your currency portfolio specifically. In this instance, you’ll look to offset the risk of trading a specific or high-volatility currency pairing, in order to strike the ideal balance between risk and reward.

But exactly do you diversify your forex trading portfolio, and what are the key points to keep in mind? Here are a few to help you on your way:

  1. Keep Your Currency Portfolio Small

Of course, the best way to diversify your currency portfolio is to invest in more than one strategically selected pairing.

However, it’s also important to keep your portfolio relatively small, as this creates a selection of similar assets that mitigate risk whilst also simplifying the process of managing your investments.

Overall, we’d recommend trading two or three pairings through a virtual broker such as ATFX,  as you look to buy at least one pair and sell another.

This affords you a chance to monitor your portfolio as adapt or scale this organically over time, in addition to studying the fundamentals of each individual trade and creating a more effective strategy over time.

  1. Perform Due Diligence

Let’s face facts; it’s important to perform due diligence when selecting one currency pair to trade, nevermind in instances where you’re to add or remove assets to an existing portfolio.

In this case, due diligence refers to the process of studying the fundamental analysis of a specific currency or pairing. More specifically, you should the economic calendar and all real-time news sources to analyse the overall market, in a bid to understand the prevailing macroeconomic factors and how they’re likely to impact on a currency.

This insight should be combined with technical analysis, which focuses on the study of associated currency charts using mathematical models.

With this analysis, you can determine exact positions at which to buy or sell currencies and offset your risk even further.

  1. Manage Your Diversified Account With Care

Ultimately, the goal of managing a diversified account is to mitigate the risks associated with one currency pair.

However, there may be times when all of your selecting pairs may underperform, even when backing relatively stable and major currency pairings such as EUR/USD and the AUD/CAD.

For example, the price may increase when buying the former, whereas the value of the latter could decline in instances where you’re looking to sell.

In this situation, you’ll need to apply knowledge of the market and common sense, whilst proactively managing your portfolio to avoid the dreaded margin call situation.

One way to achieve this is by applying stop losses and minimising the amount of capital that you deploy at any given time. As a general rule, you should only risk around 2% of your total funds in your forex account, whilst the inclusion of stop losses can automatically close positions when a predetermined level of loss has been incurred.