Diversification in investing

Whether you’re trading stocks, currency, or options, an important part of reducing risk is diversifying your investments. Putting all your money on one horse is high risk and the sign of a gambler, not an investor. No technical analysis or momentum forecast is 100% reliable, and any investor should expect periodic drawdowns.

Investment diversification – 3 factors to consider.

It helps to break down the topic into different issues that you consider individually before combining them for a final investment decision.

  • Risk and reward

  • Diversification of exposure

  • Portfolio rebalancing

Risk and reward

Every investment instrument or strategy has a certain risk profile, and you should be aware of it. Similarly, each approach has a potential reward profile. In most cases, the reward is directly proportional to the risk. This means that the more profit you hope to make, the more risk you should be willing to take. A good investor tries to balance this.

For example, ETF trading is low risk, but the return on investment (ROI) barely exceeds the rate of inflation. DITM (Deep-in-the-Money) options trading can increase reward without increasing risk. Buy and hold stocks (for stocks with good fundamentals) can be profitable, especially if you reinvest dividends. Selling covered calls in your stock portfolio can increase investment returns without increasing risk. Buying call options is very risky unless you are an experienced swing trader, but the rewards are amazing. Selling option spreads is slightly less profitable in the long run, but the risk profile is even lower than that of buy-and-hold strategies.

Diversification of exposure

The market has different sectors and each sector has different patterns of cyclical growth or decline. Your investment plan should include stocks or options from each sector. As money flows from one sector to another, you can track it and plan your investments accordingly. You should never have more than 2-3% of your portfolio dedicated to a particular stock, and you should never have more than a 20% allocation to a particular sector.

Portfolio balancing

Every year or every quarter you need to check how balanced your portfolio is. Over a period of time, some sectors will grow while others will remain static or shrink. This can leave your portfolio unbalanced. As a responsible investor, you need to balance the diversification of your investments. So maybe you’ve split your portfolio evenly between Forex, ETFs, REITs, put options, and your favorite buy-and-hold stocks. If you make significant profits from selling options, you can take those profits and reinvest them in other sectors to keep the ratio the same.

Learning curve

It’s easier, but riskier, to stick to one investment strategy. It is worthwhile to invest educational efforts in different strategies. This can be one of the most important factors in reducing the risk profile. Serious investors who don’t want to gamble will make this investment. Investment diversification is one of the most powerful drivers of profit because it prevents you from losing money.

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