Why is diversification so importan for traders and investors

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Why is diversification so important? Investment example with FinmaxFX broker

There are so many diversification examples around us even in usual daily life, we just can’t see them. Have you ever tried to eat the same food three times a day, seven days a week? That would be the best experience, would it? Why people always change dishes, menus, cuisines? Their bodies need to diversify the products they get. Why large car producers or any other manufacturers prefer to have different supplier for their parts? They need to broaden risks. What would happen if one supplier stopped sending parts to the manufacturer? The production will stop, sales will halt, salaries won’t be paid, investments would not be returned, etc. The same way financial managers and institutions distribute losses. Yes, losses. Investing and trading in the financial markets is not about dealing with profits. It’s about how you manage your risks. What is the crucial operational factor for a trader? Right, that’s a likelihood, a chance. Traders deal with probabilities of how far and how fast and where could go this particular financial instrument. That is why they manage risks in their trading decisions for any specific asset. But what if you had a certain number of assets in your investment portfolio?

Diversification is an investment approach aimed to minimise risks related to the trading process. This approach suggests spreading or distributing financial risks or manufacturing resources to different sectors and fields. This strategy became widely used in the foreign exchange market as it helps lowering losses in trading.

Diversification types

The main idea is to allocate trading capital to different asset classes which are not related to each other. There are several directions of that distribution in forex trading:

в—Џ Platforms diversification. Traders can open many accounts with different brokerage companies and trade with all of them at the same time. If one company was blown up, or the trading conditions were not so attractive for a trader, then a couple of other accounts with other brokers would remain in reserve.

в—Џ Investment types diversification. It is possible not only to trade in the FX market but also benefit on binary options type of trading or speculate on company shares in stock exchange. If the FX market was not providing the best conditions to profit, traders would always benefit on binary contracts even during a sideways consolidation range.

в—Џ Asset diversification. Traders should not rely on getting profits from currency pairs only. FinmaxFX has more than 400 instruments for trading on. Traders can trade on different asset classes or invest in various investment projects in order to play it safe, avoiding the subsidence of the account balance.

в—Џ Trading strategies diversification. Several trading systems might be used at the same time. Those algorithms might not only focus on trading on different assets but also on different timeframes, while the financial instrument would remain the same. For instance, the same asset might show a buying opportunity on the one-hour timeframe, while the 4-hourly chart would signal to sell it. FinmaxFX trading terminal remarkably has 21 timeframes to spread risks in this way.

Below is a list of recommendations on how to trade in the forex market using diversification

в—Џ The investment portfolio should contain uncorrelated assets, i.e. financial instruments which have minimum relation to each other. That conditions allow getting profits from trading on one asset while the analysis of the other points to a tough period to make a deal. For example, traders can open positions on the USD/CHF currency pair, which is usually considered as a quiet harbour, and on GBP/JPY jumping for higher distance measured in pips.

● Avoid investing large amounts into the trading account initially. Traders can start with something small and grow the trading account step-by-step. For example, a moderate amount of $100 is enough to begin trading with FinmaxFX broker. Of course, a more substantial amount is needed to get access to all of the company’s offers and benefits. However, $100 is enough to start making money. Risks diversifications suggest opening two small accounts with two brokers but not one large account with one broker.

● Brokers often offer bonuses for first-time deposits. Traders and investors should carefully consider all of the broker’s bonus conditions before accepting the offer as some of them aren’t achievable for everyone. Bonus offers might be accepted just in case if a trader is entirely self-confident.

● Part of the profit has to be regularly withdrawn to avoid the risk of losing the account balance due to technical or economic reasons. Traders should determine an optimal amount to get access to all of the trading instruments and broker’s services, while the rest of the funds should be transferred to another account or withdrawn. FinmaxFX allows withdrawing funds to credit and debit cards, wire transfers or e-wallets, while the average time of withdrawal takes one day and some accounts could do that in 5 hours.

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In general, the diversification of investment risks helpt protecting the capital from losing it, compensates losses when trading on correlated assets and provides reasonable terms of getting profits. Like any other money management method, diversification has disadvantages, the main of which is that decreasing risks suggests lowering potential gains. Investors should not rush for super profits, trade too aggressively or irrationally in the forex market as that would lead to the overall crash of the trading account at the end of the day. It would be much better to develop your own strategy, according to your style, and compose a portfolio of several high-yield assets.

If you face difficulties in creating your own investment portfolio, you might choose an existing solution developed by powerful FinmaxFX team consisting of experienced traders. They made a comprehensive fundamental and technical analysis. As a result, they designed 3 investment portfolios with an average return exceeding 130%. All you need is just to sign up on FinmaxFX website and get a consultation about the investment conditions with the broker to make sure that this result is achievable.

“General Risk Warning: Binary options and cryptocurrency trading carry a high level of risk and can result in the loss of all your funds.”

Diversification: what is it, and why is it so important?

Posted 2 August 2020. Categories: Peer-to-Peer.

Posted 2 August 2020. Categories: Peer-to-Peer.

Achieving a diversified spread across your investment portfolio can be a key predictor of positive returns – backed up by platform data from heavyweights like Lending Club, as well as industry commentators like Lend Academy, Orchard and Lending Memo. But how does it work, and how much is enough?

Why is diversification important in P2P?

Most people with experience in any form of investment understand the importance of diversifying – not putting all your eggs in one basket. The same applies within most peer-to-peer lending marketplaces.

With the traditional (typically American) model of P2P, where Lenders bear the risk of any defaults, spreading one’s investment across a multitude of loans, avoiding over-representation in any single loan, helps lessen the effect that losses may otherwise have on a portfolio.

Fractionalisation, which is typically employed by most P2P marketplaces, enables diversification to quite a broad level. At Harmoney, for example, all loans are fractionalised into $25 “notes”, and Lenders are able to spread their investment broadly across the marketplace, with as little as a $25 at risk in any one loan.

How does fractionalisation and diversification reduce the impact of losses?

Here’s an example:

Say John and Lucy each have $5,000 that they’d like to invest in Harmoney.

John chooses to split his investment across 2 loans, with $2,500 in each.

Lucy decides to diversify her investment at the maximum rate – investing $25 into 200 different loans.

Both John and Lucy invest in a loan which defaults. John’s portfolio takes a significant hit as a result of the default, because the loan represented 50% of his portfolio. But Lucy’s account is only minimally affected, as the loan only represents 0.5% of her total portfolio.

Now – this is a very simplistic example, but it shows the theory: the more diversified every individual Lender is, the less volatility their portfolio is likely to experience, and the more likely they are to experience a positive return.

Does the data back up the theory?

Let’s take a look at Harmoney’s data:

In the above graph, you’ll see the X axis shows the number of notes invested by an account, while the Y axis shows the Realised Annual Return (RAR). Low on the X axis, there’s a huge spread of volatility in RAR, but as you get higher, that volatility decreases significantly. Harmoney’s current data shows that 100% of Lenders with 100 or more distinct loans in their portfolio are experiencing positive returns. (Check out Marketplace Statistics for more information)

Lending Club’s data tells a similar story – portfolios with 100+ notes, where no individual loan accounts for more than 1% of their portfolio, have a 0.04% chance of experiencing negative returns. Additionally, Lending Club’s data shows a similar result when looking at note count and return volatility.

Looking for some other tips on diversification?

We’ve trawled the strategies of industry insiders around the world. Here’s a selection of great articles about it:

According to Lending Memo, “The most important thing in P2P lending [is to] invest in 200+ notes.” Check out their blog to see why they make the argument.

Always a good starting point for anyone getting into P2P, check out Lend Academy’s introduction to Diversification.

Though slightly old now, this blog post by Orchard’s Angela Ceresnie is still worth the read.

Bond Mason argues that “beating the market isn’t always possible, and an important secondary objective should be to do no worse than the market in terms of investment losses.” Have a read of their thoughts.

Investor Junkie rates diversification as “the most important point of all” in their blog post, “Five ways to improve your P2P Investment”.

Why diversification is so important for your investment portfolio Why diversification is so important for your investment portfolio

In an exclusive article, Clement Bigot, the senior investment associate at Seedrs, tells What Investment why he thinks diversification is fundamental to investing intelligently.

Clement Bigot, Senior Investment Associate at Seedrs

Bigot says, “It’s a technique by which investors invest their capital across a number of different asset classes, geographies and industry sectors in order to minimise their risk. Rather than making one investment, they create a portfolio of multiple smaller investments in assets that have different price and risk characteristics, so that on average the investment portfolio will yield a higher return on investment and pose a lower risk than any individual investment.

“Its role is well understood by investors in the public markets but may not be in the private markets, particularly in the early stage segment, where it is arguably most crucial. In the public markets it may mean investing in a balanced portfolio of ETF trackers, bonds and cash, but how can diversification be applied to early stage investments?

Investment portfolio management

“For early stage investing, it’s important to understand the most likely risk to an investor and how it affects a portfolio when looking at companies to invest in: company failure. This is generally not something an investor thinks about in the public markets, or even in much of the private market when choosing investment options. It is generally accepted by most professional Venture Capital investors that venture backed startups follow a power law. That is, most early stage companies will fail, some will return a little bit and a small few will return an oversized amount. For an early stage portfolio with a relatively small mix of investments it’s more likely that they will all fail than all succeed, but if one company does succeed then you can expect its return to be magnitudes greater than anything else in the portfolio. This is how most professional venture capital funds think about their investments and portfolios.

“As startups are so risky, an early stage investment portfolio requires a small number of investments to be highly successful, to provide the returns necessary to compensate for the investments that have failed as well as provide a satisfactory return for the risk taken. For its success, this means it’s important the portfolio has exposure to potentially hugely successful companies, but as the probability an investor will be able to choose the winning company every time is very low, investing across a number of companies becomes paramount.

“Of course, we all hope that we have the foresight to tell which industries are going to shape the future and which companies within them will be the key drivers, but the reality is that is unlikely. Instead, an investor should spread their investable capital across a large number of businesses that have the potential to return large amounts. This is why many investors look at the potential size of the market when deciding whether to invest. The question is; if this company does succeed, how big can the company go, and could it return enough to provide a positive return to my overall portfolio if the others don’t succeed?

“Unfortunately, the high fixed costs and risks associated with investment portfolio management in the private market, particularly at the earlier stage, has historically meant that its use as an asset class within a wider diversified portfolio has been reserved for a small, generally very wealthy segment of the population who can afford to make the deal economics work. This means a large portion of the population who otherwise hold well diversified, well balanced, financial investment portfolios nevertheless miss out on an important asset class. While very risky, early stage investments can have an important impact on a portfolio as returns generally don’t follow the returns of the public market and there is the potential of high returns in an otherwise low rate environment.

“However, the cost of participating in the private markets and in early stage businesses in particular is dropping drastically. The roles of equity crowdfunding platforms like Seedrs and peer-to-peer debt platforms allow everyday investors to invest in the equity or debt of small and early stage businesses for very small minimum investment sizes, democratising the asset class for all. For a very low cost, an investor can diversify their portfolio and optimise its risk-return level using exposure to companies at an early stage of growth, rather than only in the public markets.

“Harry Markowitz, the pioneer of modern portfolio theory, said that diversification is the only free lunch in finance. With a well diversified portfolio, an investor can expect to reduce the risk of their portfolio for the same level of return. As long as the risks are well understood and portfolios are structured accordingly, investments in the private market, in particular high growth startups, can play a crucial role in achieving this.”

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