Whether you trade stocks, Forex or options, an important part of risk reduction is investment diversification. Putting all your money in a horse is high risk and is the sign of a player, not an investor. No technical analysis or momentum prediction is 100% foolproof and all investors should expect regular drawdowns.
Investment Diversification – 3 factors to consider.
It is helpful to break the topic down into different questions that you consider separately before bringing them together for the final investment decision.
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risk and reward
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Exposure diversification
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Portfolio rebalancing
risk and reward
Each investment vehicle or strategy has a different risk profile, and you should be aware of this. Similarly, each approach has a potential reward profile. In most circumstances, the reward is directly proportional to the risk. This means that the more profit you expect to make, the more risk you must be willing to handle. A good investor tries to balance this.
For example, trading ETFs is low risk, but the return on investment (ROI) is just above the rate of inflation. Trading DITM (Deep-in-the-Money) options can increase reward without increasing risk. Buy-and-hold stock trading (for a stock with good fundamentals) can be profitable, especially if you reinvest dividends. Selling covered calls in your stock portfolio can increase your ROI without increasing risk. Buying call options is very risky unless you are an accomplished swing trader, but the rewards are incredible. Selling option spreads is slightly less profitable in the long run, but the risk profile is even lower than buy-and-hold strategies.
Exposure diversification
The market has different sectors and each sector has different cyclical patterns of growth or decline. Your investment plan should include stocks or options from each sector. As money flows from one sector to another, you can keep track and plan your investments accordingly. You should never have more than 2-3% of your portfolio committed to any particular stock and never have more than 20% designated for any given sector.
portfolio balance
Every year or every quarter, you should look at how well your portfolio is balanced. In a given period of time, some sectors will grow while others will remain static or contract. This can leave your portfolio unbalanced. As a responsible investor, you need to rebalance your investment diversification. So maybe you’ve divided your portfolio evenly between Forex, ETFs, REITs, selling options, and favorite buy-and-hold stocks. If you make big profits selling options, you can take these profits and reinvest them in other sectors so that the ratio remains the same.
The learning curve
It is easier, but riskier, to stick to an investment strategy. It is worth investing educational effort in several strategies. This may be one of the most important factors in lowering your risk profile. Serious investors, who have no desire to gamble, will make this investment. Diversification in investing is one of the most powerful earning factors, simply because it prevents you from losing money.