Investing in financial markets is all about managing risk. The most time-honoured and usually most effective method is portfolio diversification. The best way to understand portfolio diversification is the old adage about not putting all of your eggs in one basket – by balancing a portfolio across uncorrelated assets, investors can protect themselves from downturns, without limiting their returns.
What is a diversified portfolio?
Whether you have an equity, forex, or commodities portfolio, diversification will be the main tool to protect your long-term investment gains. By investing different weighted amounts of your portfolio to different assets, you can avoid destroying the value of your investments when one of them fails, an industry struggles, or when a country goes into recession.
For example, as a currency trader who mostly deals with AUD/NZD as a pair, you may find that your portfolio is vulnerable to a downturn in either currency, as they are quite strongly correlated. Additionally, since AUD in particular is viewed as a commodity-linked currency, other currencies which closely track the price of commodities, or commodities themselves such as base metals, might also contribute to a portfolio where all the assets are highly correlated, and therefore not diversified.
Instead of holding multiple correlated assets in one portfolio, it is good risk management practice to hold a diverse basket of currencies. A long trade in AUD/NZD could be offset by a EUR/GBP or short AUD/USD trade, spreading your portfolio’s exposure across multiple, uncorrelated assets.
Why does a diversified portfolio matter?
Over long trading periods, the most important rule is always not to lose money. Market participants who rely all the time on one currency pair, equity, or commodity, will often find themselves in trouble during market downturns.
In theory, this is straightforward enough, but things can swiftly become more complicated. Some correlations only appear at certain times, and general market sentiment, particularly when losses are feared, can cause downturns across multiple uncorrelated assets.
The traditional view: Correlation
Correlation is a simple measure of the interrelatedness of two values. If A and B have a correlation of 1, they will move in lockstep; an increase of A by 100% would see an identical 100% increase in B. A correlation of 0.5 would mean 50% of the price move in A is seen in B, so if A moves up in price by 20%, B will move up by just 10%. Correlations change all the time, but they tend to stay close to long-term averages.
Within forex, examples of closely correlated pairs would be GBP/USD and EUR/USD, which show a correlation of about 0.77. Some currency pairs are negatively correlated, meaning they tend to move in the opposite direction. This is rarer, but an example would be USD/JPY and EUR/USD, at -0.09.
The goal of portfolio diversification is to manage market risk by holding a basket of uncorrelated assets. Therefore, even if the price of some of your investments falls, others will increase in price or stay level, offsetting any potential losses. Gold has remained a popular ‘safe haven’ asset for centuries due to its lack of correlation with other assets.
Some problems in recent years
Financial markets still follow the same basic rules that they always have, but the global environment has changed considerably. The events of 2007-2009 proved that there is now such a thing as a truly global recession, where assets fall in price together.
The ease of investing across borders and the search for returns worldwide means that investors hold extremely geographically diverse portfolios, in multiple asset classes, across many countries. This increases the correlation between asset prices and the likelihood of ‘contagion’.
It’s easiest to explain this with an example: Imagine you are an investor with a diversified portfolio, of metals companies in India, Chinese consumer goods manufacturers, and American financial firms. Now also imagine that the Norwegian sovereign wealth fund, one of the largest in the world, holds large investments in Australian mines, US banks and shipping companies based in Singapore. These investments would not appear to be correlated when looking at recent price history.
If poor economic conditions in Norway mean the sovereign wealth fund is forced to sell many of its investments, that could result in financial difficulties for all three companies, possibly including a collapse in share price or difficulties accessing credit. This in turn could lead to credit difficulties for the bank’s other customers, supply problems for the Indian metals processor, and delays in the delivery of Chinese goods to overseas customers.
Therefore, an investor with a well-diversified, but very unlucky, equity portfolio based on a mix of those companies would be badly hit by these hidden linkages. What’s more, these assets would not display any correlation until the event happened, as the links are only revealed under conditions of stress. In extremely poor market conditions, many normally uncorrelated assets will rapidly lose value because of effects like this one.
‘Risk on’ and ‘Risk off’
Two terms you will hear in any risk management discussion are risk on and risk off. These refer to two different market risk environments:
Risk on occurs when traders rotate into high growth, high volatility assets, especially equities, but also commodities, commodity-linked currencies and risky corporate debt.
Risk off occurs when traders, apprehensive about the market risk levels in their portfolios, rotate into ‘safer’ assets such as gold, the US dollar, and the government debt of large economies.
A diversified portfolio will include a mixture of ‘risk on’ and ‘risk off’ assets. For a currency portfolio, this could mean a short USD/BRL position is balanced by a long EUR/USD or short AUD/USD position. In the above scenario, the BRL and AUD are both risk on assets, AUD because it is commodities linked, and BRL because it is both commodities linked and an emerging market currency. The USD and EUR, as international reserve currencies linked to large, developed economies, are both risk off assets.
Most research into market risk looks at equity portfolios since this is where the majority of retail investors put their savings. Although the overall volumes of the forex market are much larger, market risk is typically reduced for a number of reasons:
- Forex trades normally have a much shorter time frame than equity investments, resulting in a lesser chance of large price moves.
- Secondly, the vast majority of forex trades involve the US dollar as one side of the trade, and usually another major international currency on the other, which show much lesser volatility than exotic pairs.
- A currency is unlikely to lose all of its value.
It’s still important not to be complacent – the 2015 devaluation of the Swiss franc is just one example of a previously ‘solid’ currency suddenly entering a period of volatility, strengthening against the US dollar by 25% in a single day. Likewise, between June and October in 2016 the GBP/USD exchange rate went from 1.49 to 1.22. This may not seem like a huge move, but when you factor in the effect of leverage, an 18% swing is more than enough to ruin a forex portfolio.
Outside of the main currency pairs, volatility is even more dramatic: Between July and December 2021 the USD / TRY (Turkish Lira) exchange rate went from around 7 to over 17.
Tips to remember
- Make sure, particularly if you hold trades over longer periods, to diversify your portfolio with different, uncorrelated currency pairs.
- Try and be aware of hidden links, or correlations which only appear at certain times.
- Be mindful that correlations can break down, particularly in major market corrections.
The benefits of a diversified portfolio
Asides from the risk management benefits, having a well-diversified currency portfolio ensures that you get familiar with various currency pairs, instead of just relying on one or two. Since different pairs trade quite differently, and require different levels and interpretations of technical analysis this is an important part of learning to trade effectively.
How Rakuten can help
Diversification is an important concept to become comfortable with as early as possible on your investment journey.
If you want to start looking at correlations, and finding some new currency pairs to diversify your forex portfolio, why not sign up for a free demo account today and start placing trades without risking any of your capital?