In finance and investment, when we talk about “portfolio”, it’s also very easy to hear about the concept of “diversification”.
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The concept of diversification, all in all, is pretty simple. In fact it means:
having in the portfolio various financial instruments and various underlyings for financial instrument, in order to reduce the overall risk of the portfolio.
“Financial instruments” mean the macro-categories on which you can invest, i.e. currencies, equities, bonds, commodities, derivatives, futures, options and so on.
Instead, “underlyings” means the specific products of these macro-categories, such as the single currency pairs like EUR/USD for currencies, Google shares for equities, the US Treasuries for bonds, gold for commodities, etc.
In other words, diversification means investing on many fronts, on multiple instruments, different in nature, characteristics and degree of risk, so as not to depend on the fate of a single investment.
One of the most important things to understand about the degree of diversification is that it doesn’t depend on the “quantity” of the investments included in the portfolio, but more on their nature and their correlation.
As Warren Buffet often said: “Wide diversification is only required when investors do not understand what they are doing.”
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The principle of correlation
To get a diversified portfolio it’s not necessary to enter a lot of instruments and underlyings. What matters most is to consider their nature and the correlation between them.
A positive or negative correlation between two instruments is the tendency to move respectively in the same direction or vice versa. It’s always important that this is very low or non-existent, so that the returns move independently from each other.
If the components of the portfolio are too interrelated, perhaps positively, there’s the risk that the entire portfolio turns loss-making at the same time, creating potential risk situations.
In case of negative correlation, instead, the profitability of the portfolio could be affected, because the profit of an instrument could be equal to the loss of the other, or vice versa.
For this reason it’s always advisable to pay attention to the correlations and, where possible, keep them to a minimum, so that the performance of the instruments are truly independent, and so diversified.
The benefits of diversification
A proper portfolio diversification leads to the obvious benefits of reducing volatility and protection against high drawdown risk.
These two concepts often go together, but it’s important to identify them.
- Volatility: it’s the speed of movement of the individual underlying, i.e. the percentage change of an instrument in relation to time. The more the variation is high in a short period of time, the more the volatility is high as well. Clearly, this concept is valid for the individual underlying as well as for an entire portfolio, which is given by the sum of them. You can guess how this, on the one hand, is an advantage, because it gives you the opportunity to earn large sums of money in a short time, but on the other is also a risk, because in the same way it puts you in a position to quickly lose those same money you could earn. As mentioned earlier, two instruments related positively could increase the overall volatility of your portfolio, thus increasing the risk of the unexpected.
- Drawdown: the loss of invested capital caused by the negative performance of a financial instrument or by all the financial instruments included in your portfolio. A non-diversified portfolio, or bad diversified and so unbalanced, might run into abrupt and sudden drawdowns just because of the simultaneity of the negative performance on the various assets.
The objectives of a diversified portfolio
The first goal of a diversified portfolio, then, becomes to break down the overall riskiness of the portfolio by controlling its volatility and the potential drawdowns.
Next, the second goal must be to look for the best investments that, with the same risk, will allow the best returns.
In other words, first of all we have to understand how to protect our investment, and ensure that it can survive in times of market turbulence. After that, we can look for the best opportunities to be included in the portfolio to try to maximize profit as much as possible, but without increasing the risks.
In recent decades a lot has been written about the correlations between the various assets (equities, bonds, indexes, commodities, currencies, etc.) and about how to include them in the portfolio. Some of these theories may be very useful, since with eToro you can also invest in stocks and commodities, or replicate the operations of those who do.
However, in a People-Based Portfolio, i.e. in a portfolio where the assets are not investment instruments, but people, or rather traders, the logic at the base is different.
We will deal with these very important topics in detail in the eToro Advanced Course, but let’s start by seeing here the main concepts.
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Diversify your portfolio with eToro
Diversifying the portfolio when you invest in Social Trading is a slightly different concept, or rather “new”, given the young age of this investment practice.
The founding tenets of the diversification of a People-Based Portfolio are essentially 3. Let’s see them together.
– Diversifing the trading style
Investing with Copy Trading means to replicate the transactions of other traders. Having thousands of them to choose from, it becomes useful thinking about their operating style, the way they operate, the strategies and instruments they use, in order to diversify the choice of traders to be replicated even by these factors.
In the Social Trading Course we have dedicated a lesson to the main categories of traders you can find in the companies of this sector.
Given the fact that there is not one identical to another, and many times a trader is actually a mix of two categories, the most important thing not to overlook is always the control of risks and the portfolio protection.
This means that, beyond his operating style, a trader should always observe certain logic that makes him reliable for an investment. If it’s down your ally or not, and is compatible and useful to be included in your portfolio, you’ll understand in the second phase.
– Diversifing the underlyings
Another important factor of diversification is given by the underlyings.
Not all the Social Trading companies offer the possibility of implementing this type of diversification. With ZuluTrade you can only trade on Forex, and in that case you can only diversify the types of currency pairs. For example, you can diversify by choosing specialized trader on currencies like sterling or yen in order to not be too unbalanced only on euro or dollar.
With eToro you can do the same, but also and above all, thanks to the CFDs, you can diversify on traders and investors who use completely different asset classes such as stocks, indexes and commodities. Plus, eToro is also one of the few with which you can actually get Dividends (here’s our eToro Dividends post to learn more) .
Being a Social Trader, or, in this case, rather a Copy Trader, your task will be to identify the investors experienced and capable in their respective asset classes, and allocate them in your portfolio as well.
Each trading strategy, no matter how good the trader is, suffers moments of negative variance caused by both the characteristics of the strategy and those of the underlying. Copying different investors who work with different strategies on different underlyings offers the possibility to exploit the winning moments of a strategy on a given market in compensation to more difficult market moments for strategies that work on other underlyings.
– Diversifing the leverage
Third and final main element of diversification in Social Trading is the financial leverage.
In this case we mean the leverage used to replicate the trading signals generated by the traders and investors included in your portfolio.
The first point to remember is that overdoing with leverage is never advisable, because it can cause major problems in the portfolio on both volatility and excessive drawdowns. So, even diversifying, you should never go beyond a certain limit.
Second, the leverage must be distributed according to the operating characteristics of the strategy of the trader, considering how much it is strong, constant and risky.
It’s not certain that a trader with a strategy somewhat aggressive, so potentially risky, should be dismissed out of hand. Within the bounds of common sense, the risk may be leveled with a lowering of the assigned leverage, in order to make it conform to the general parameters of the portfolio and not create imbalances.
You must always be very careful even with traders who seem very reliable, and do not ever overdo with the leverage. Although they have shown reliability, a sudden error or malfunction of the strategy, combined with a high leverage ratio, may cause great damage to the portfolio.
As you can probably gather, diversifying the leverage is definitely the most risky activity of the three, and this must be done with extreme caution and care, after studying in detail the characteristics of the trader and, even better, after you’ve tested him.
Anyway, even though the study and the deepening are fundamental, only a certain degree of direct experience can help to make optimal choices in this field.
However, experiencing with your eToro live account is definitely not advisable, which is why the eToro virtual portfolio becomes really important, because you can even simulate the actual movement of money and the degree of volatility, drawdown and the portfolio overall risk before you start.
Not only that, even when you’re investing in the real one, you can always use the eToro virtual portfolio to test variations or alternatives, and continue to study and improve your investment.
Having said that, we have concluded the basic course. You just have the last lesson.