One of the most effective strategies that can be used to mitigate risk is to diversify. Allocating your assets to multiple types of investment strategies and assets protects you from an adverse market move. The term “don’t put all your eggs in one basket” refers to the notion that if you only buy one asset, you might find that if something goes wrong you could lose all of your money.
What is Asset Allocation
Part of the investment process is determining where you will trade your money. If you are a very conservative investor you might consider keeping some or most of your funds in a money market fund or a bank CD. The risk of losing money in a bank certificate of deposit is nearly zero, but the returns you will receive are small. Alternatively, you might consider riskier assets such as stock, indices, forex, and commodities. The more money you allocate to riskier assets, the more you are likely to make over time. There is a risk versus reward ratio that you need to calculate as you determine where you will allocate your funds.
Diversifying Your Portfolio
Once you determine that you want to allocate to a riskier asset, you should evaluate how to build a diversified portfolio. Diversification is important as it provides a way to mitigate your risk. If you diversify the money you allocate to riskier assets you can avoid a situation where an adverse market move wipes out the funds that you have in your portfolio. Diversification is defined as a risk management strategy that mixes several investments within a portfolio. On average, you will make more than holding individual security and avoid the risk of ruin.
The Basics of Diversification
The goal of a diversified portfolio is that it smooths the retuns of the funds you have allocated to riskier assets. In many cases, the assets will be uncorrelated to one another meaning that the returns do not move in lockstep. When you have losing money in one asset, you are likely gaining in another. As a money manager, you want to diversify your investment across multiple asset classes determining what percentages to invest in each. You could equally break down your funds, or allocate them into assets that you feel the most comfortable trading. Some of the most popular are stocks, bonds, forex, commodities and indices. Many asset managers are also now trading cryptocurrencies.
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Using ETFs to Diversify
One of the best ways to create a diversified portfolio is to trade ETFs. Exchange traded funds are pools of assets that provide exposure to different products. There are ETFs that focus on stock indices, commodities, as well as currencies. Stock indices could include large indices such as the Dow Industrials, or sectors such as the financial sector or the utility sector. You will also find ETFs that hold only gold or oil, as well as currency ETFs that trade in lock step with popular currency pairs. By allocating your funds to multiple ETFS you can create a diversify portfolio.