Why Should We Diversify?

Thinking of the concept of variety. Just like the old saying goes “never keep all of your eggs in the same basket” – diversification is a call for the creation of a portfolio that contains a wide variety of investments. The rationale behind this strategy – invest in multiple asset classes is to neutralize the negative yields of some investments with the positive yields of other investments in the portfolio. 

To put it in a simpler way, let’s say Amanda and Steven are both traders who have the same initial fund. Amanda decided to put all her start-up funds into the U.S. Dollar while Steven decided to implement the diversification strategy by trading the Dollar and Japanese Yen respectively. 

Of course, when the U.S. economy is booming, both of the traders gain profits but when the U.S. economic growth stagnates and drops, Amanda has more to lose compared to Steven who still gets to offset his negative dollar yield with the positive yield of Japanese Yen from practicing diversification. 

This is how diversification comes in handy in times of difficulty. It keeps traders sane, just like how Billionaire investor Warren Buffett argues, “diversification is protection against ignorance,”. It strives to smooth out unsystematic risk events in a portfolio, especially during times of uncertainty. Trades are encouraged to diversify their portfolio with currencies that have low correlation, just like how Steven does. For instance, forces depressing the US economy may not affect Japan’s economy in the same way. Therefore, holding the Japanese Yen gives traders a small cushion of protection against losses during an American economic downturn. 

Other than offering risk management, another plus of diversification is the better long-term returns it brings. An adequately diversified portfolio tends to post higher returns in the long run. Add in, hedging against the market volatility to prevent traders’ accounts from getting all wiped out. 

However, on the flip-side of the coin, it can get time-consuming to employ this strategy. This is because traders have to do twice the work in studying. Instead of just studying one currency, they have to analyze and observe two types of currencies. Moreover, it also entails more brokerage commission and transaction fees as multiple trading accounts might be needed for different assets. But, even though the time and budget constraint might be a big drawback for traders but the long-term returns and mitigated risk may save your trading account anytime. 

To sum up, some traders might not totally agree with the diversification concept but investing or trading only one currency is definitely not a sensible approach. Maybe spreading investments across a wider range of assets is not a sure-fire way for traders to gain profit but it surely is one of the great ways to reduce the trading account’s exposure to volatility as much as possible and prevent it from getting unduly affected by a bad economy. Think of it as an insurance policy – better safe than sorry. 

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