We all have heard the expression “Don’t put all your eggs in one basket”. This is essentially the main idea behind diversification. When you put all your eggs in one basket, you are becoming too dependent on the performance of one particular market or asset class. What if that one market or asset class is caught up in a situation of bubble which will burst? This is an example of why you should diversify across several asset classes!
Harry Markowitz famously studied the relationship between a portfolios’ risk and return. He defined the “efficient frontier”, that which gives the highest returns for a pre-defined risk level. A minimum variance portfolio is that which provides us with the lowest level of risk possible, combined with the highest possible return.
Everything depends on individual risk tolerance levels, but traders should know what benefits their diversification provides them with. Benefits should indeed be immense, both from a risk management perspectives and because with portfolio variance being lowered, the performance of the portfolio itself can be predicted with greater level of certainty.
When diversifying a portfolio, traders should pay a close attention to the correlation levels of different assets. If two assets are perfectly correlated, i.e. their prices change in a similar way with the passage of time, then the benefits of diversification will be lower. It is also important to understand what happens when a currency’s value is changed. For example, USD is the currency that many commodities are denominated in. The change in value of the USD might also affect those assets.
So we would highly recommend the use of a diversified portfolio across different asset classes. You will then be able to observe the benefits of such an approach in your trading.