Manage Risk Through Portfolio Diversification

Manage Risk Through Portfolio Diversification

Portfolio diversification is a good way to manage trading risk by ensuring that you invest in a variety of instruments. The logic behind this is that a portfolio that is made up of different classes of assets will yield better long-term returns, since poor performance of one asset class would be offset by better performance in another. As the saying goes, never keep all your eggs in one basket.

The main aim of diversification is to smoothen out any unsystematic risks. One thing to remember, however, is that you will get the benefits of diversification only if the assets in your portfolio are negatively correlated to each other. Assets that are negatively correlated would respond differently to market changes, and in most cases, even move in opposite directions.

Here’s a look at some assets you can consider to diversify your portfolio.

Diversification by Adding a Foreign Currency

Addition of a foreign currency to your portfolio can be done by investing in foreign currency denominated assets. Depending on your investment objectives, you could also add a foreign currency to improve the portfolio balance.

This kind of investment could be an investment in the stock of a country. A country that has a good track record of economic growth is likely to have a strong currency, as compared to a country with a weaker economy.

Another way to diversify your portfolio is include a commodity currency in it. This could help hedge against inflation risk up to a certain extent. And, if the commodity currency is from a gold exporter, such as Australia, or an oil producing nation, such as Canada, the hedging ability is likely to be robust.

Whenever a particular currency is falling, there are always others that are rising in value. So, the forex market offers a lot of opportunities for traders who invest using a definitive strategy. Currencies of the US, Japan, Europe, Australia, Canada and New Zealand are considered commodity currencies. Investment in the form of assets or cash in any of these currencies can be potentially beneficial while aiming to diversify your portfolio.

Despite the fact that inflation affects the value of money on a global scale, choosing a suitable currency for your investment portfolio can help improve your potential for achieving good returns.

Diversification Through Cryptocurrencies

Bitcoin is one cryptocurrency that can play an important role in diversification. This is mainly due to its unique nature and characteristics.

1.    Low Correlation

A study of Bitcoin’s price fluctuation, in comparison to the movement of fiat currencies, bonds, stocks and gold, shows that the cryptocurrency does not follow those asset classes very strongly.

A paper written by academics at Paris Dauphine University stated similar conclusions. The analysis concluded, “The Bitcoin rate of return presents statistical characteristics that differ markedly from those of other assets, including gold, oil, and hedge funds. In addition, Bitcoin investment is attractive because it delivers exceptionally high diversification benefits. This is due to low correlations not only with traditional financial assets but also with alternative investments.”

Due to low correlation values, you can potentially use this cryptocurrency to help reduce the volatility of the investment portfolio.

2.    Investment During Good Times

A smart way of using Bitcoin for diversification is to invest in it as a hedge during strong economic conditions. During such times, risky assets such as stocks, oil and high yield bonds tend to push higher. So, you might think that including them in your portfolio will benefit you. But including a safe haven asset such as Bitcoin can help you decrease downside risks (risk of losing value) to your portfolio, in case the conditions change for the worse.

3.    Helps Maintain a Risk Tolerant Portfolio

Let’s say you choose to create a portfolio using high risk assets that include 20% high yield bonds, 20% real estate, 20% oil and another 20% stocks. In this case, you could opt to add Bitcoin in order to fill up the remaining 20%. This is because oil, stocks, bonds and real estate move in the same upward direction when the economy does well and they tend to lose value quickly when things start to go downhill.

4.    Hedging in Times of Crisis

Along with providing a high level of diversification during strong economic conditions, Bitcoin can work even better in times of crisis. During the 2008 financial crisis, a number of assets suffered major losses, which led to a high correlation developing between certain asset classes. This then means that investors could not diversify and protect their portfolios from downside risks. This, of course, happened before the introduction of Bitcoin. And, since its launch, the “people’s currency” has managed to show significant gains in times of crisis.

If Bitcoin continues to act in the same manner, you may well be able to hedge your portfolio against downside risk. In case the market’s aversion towards risk increases by a great extent, Bitcoin’s value could increase sharply. This could help you recover from losses in assets such as oil and stocks.

Possible Disadvantages of Diversification

As with most strategies, there are some disadvantages to diversification too.

If you have a large number of holdings in your portfolio, it can be time consuming to manage all of them effectively. Also, the sale and purchase of many different holdings can sometimes involve more transaction fees and commissions to take care of.

So, while diversification can help spread out your investments across various degrees of risk, it could also lower the returns. So, is it a good idea to diversify your portfolio? If done correctly, diversification can help shield your portfolio against risk. But if you don’t put in much thought and care into it, it could become an exercise in futility.

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