Creating a diversified portfolio

Introduction

Diversification is an important concept for both traders and investors. You are probably already familiar with the concept from long term investment strategies, where a mixture of stocks and bonds is recommended to protect against market downturns. Diversification isn’t limited by time scale, or by asset class; traders can practice diversification investment strategies within a single market, with equity traders using a mixture of high-quality stocks to protect against market downturns. What is less well-known is that CFD traders also can benefit from diversification, something that’s often lost when looking at strategies as just a group of individual, separate trades.

The reason diversification is important for traders is correlation, or the tendency of different assets to show similar price action, moving together either by coincidence or sometimes because of a relationship between the two markets. Especially during market downturns or spikes of volatility, correlation tends to appear across markets, as seemingly random assets move together in price – usually downwards. ADSS CFD traders have lots of flexibility in dealing with this, and the existence of correlation is no cause for panic. But understanding how different assets interact will help make you a more effective trader, and maintaining a diversified trading portfolio is an important risk management tool for CFD day traders as well as traditional equity investors.

What is a portfolio?

A portfolio is a group of positions, and the term is used both in trading and investing. A CFD trading portfolio is the sum of all the open positions held in a trading account, and can be split across different products, asset classes, and geographies. An important part of risk management is portfolio diversification, which means spreading out the risk present in your portfolio over a broad group of unrelated positions, markets, and sectors. When looking at risk, traders need to be aware of how different market events may impact their portfolio, and there are different ways to do this, including backtesting and running market scenarios on a simulated or demo portfolio. These methods will give you an idea of how your trading account may perform during similar events, and as a rule a well-diversified portfolio will outperform a concentrated one during market turmoil.

Correlation

The reason diversification is necessary in financial markets is correlation, the relationship between two prices, a relationship that may be positive or negative. Correlation is measured on a simple scale, where 0 represents two assets with no connection whatsoever between their prices. If, on the other hand, asset X moves in perfect lockstep with asset Y, increasing by $1 for each $1 increase in Y, then X and Y have a correlation of 1. Correlations can be negative, when a price decrease in one is associated with increases in the other, and they can be more than 1, for example if X increases by $2 for every $1 increase seen in Y, for a correlation of 2. Correlations exist between most financial assets, with some strong, some weak, and some negative. Since financial assets are correlated, simply dividing your trading portfolio into ten different trades will not necessarily protect you from a general downturn, because the markets you are trading will often move together.

Correlations appear because of trader behaviour, so although all financial assets exhibit some degree of correlation, the relationships involved change with time. When we talk about the degree of correlation, for example between two stocks or a stock and a currency, we are talking about historical correlations over a certain period. These correlations can be expressed as rolling correlations, for example showing the correlation of daily returns over a rolling 60 day period, or a single figure for the entire period. The correlations between multiple different assets can be expressed in a correlation matrix, useful for identifying relationships between stocks and currency pairs. Over the very long term, some reliable correlations emerge that investors use to guide their portfolio selection: the most important of these is the limited or negative correlation between investment grade bonds and the general stock market. Correlations like this are driven by predictable market behaviour, with traders rotating into riskier assets when they are confident, and into safe havens when there is excess volatility. These relationships can be measured over the long term, but cannot be relied on to work 100% of the time.

Correlations between asset classes

We have already discussed the best known correlation, between equities and bonds. High quality bonds such as US Treasuries are used as safe havens when markets are experiencing high volatility, so they tend to see price increases when the equity market is in trouble. This relationship is quite reliable and works on a simple principle, but lots of correlations don’t have such an easy explanation. You can test the correlation of different assets quite easily and map them using rolling correlations or a correlation matrix, but unless you can explain why a relationship exists between two prices you should be cautious about using this information to guide your trading: historical correlations sometimes appear coincidentally, and will change or disappear at the first sign of a sell-off. Portfolio diversification requires finding assets with limited or no correlation, so it is a good idea to check the historical correlations of new assets when you add them to your trading portfolio. Stocks in the same sector, closely related currencies such as the AUD and NZD, and precious metals like gold and silver often exhibit a high degree of correlation.

Equities

Equities are a risk on asset, and so are correlated with other asset classes that perform well during periods of economic growth, credit expansion, and when traders are happy to accept additional risk to improve returns. Though there is enormous variation in correlation within equities and across different national stock markets, stocks in general are normally positively correlated with other stocks, with industrial commodities, and more speculatively with cryptocurrencies. Equities tend to have reduced or even negative correlations with investment grade debt, major pair or reserve currencies, and safe haven assets such as gold.

Forex

Forex pairs, like stocks, vary widely according to the currencies involved. Major pairs and ‘safe haven’ currencies are risk off assets and are usually positively correlated with gold, government bonds and investment grade debt. Emerging markets currencies are more likely to be positively correlated with stocks and industrial commodities. Correlation in the forex market is more complicated because there are two sides to every trade, and because the US dollar makes up one side of an overwhelming majority of FX positions. In general, price moves are smaller in the forex market than for equities, but because forex is traded with significant leverage it can still have large bottom line impact on your portfolio.

Bonds and credit

Bonds are split into two categories, investment grade and non-investment grade (sometimes known as junk bonds). The former is an archetypal safe haven asset, especially the government debt of stable economies, and is positively correlated with gold and the US dollar. Junk bonds tend to follow the price of more volatile risk on assets such as stocks and industrial commodities. The price action of bonds is severely limited because they mature at par, unless the bond goes into default. Bonds are most commonly used for diversification by long term investors, such as in a stock retirement portfolio, but ADSS CFD traders can trade Bond ETFs made up of bonds of differing maturities in German, British and American bond markets, among others.

Commodities

Commodities are perhaps the broadest and most diverse asset class, and their relative internal lack of correlation reflect this. Industrial commodities are sometimes considered as a group since they tend to move upwards during periods of global GDP growth and fall in price during economic contractions; commodities following this price pattern include oil, base metals, and rare earth metals. However, each commodity is also influenced by supply-specific concerns, so even similar base metals may see different price action. Precious metals by contrast trade like safe haven assets, and are used by investors as an alternative to government bonds. Agricultural commodities show little correlation with any other asset class, but are often volatile and so of limited value as hedges.

Cryptocurrencies

Cryptocurrency CFDs can be traded directly by ADSS traders on Bitcoin, Bitcoin Cash, Ethereum and Litecoin, or by trading CFDs on ETFs designed to track cryptocurrency prices. Some analysts report correlations between Bitcoin and other cryptocurrencies and the stock market, especially tech stocks, but these correlations are not stable and cryptocurrencies experience rapid price growth during the 2020 stock market crash. Though they can provide uncorrelated price action, because of their extreme volatility cryptocurrencies are not normally recommended for diversification purposes.

Finding uncorrelated assets

Fortunately, whether you are looking within the same asset class or not, it is easy to find uncorrelated assets. Stocks in particular can be used for internal diversification by trading CFDs on companies that operate in different segments or geographies: shares in an American utilities company and Emirati insurance company probably do not have a strong correlation. Across asset classes diversification is even easier – a portfolio made of 10 stock CFD positions and 10 FX CFDs might see correlated equity CFD losses in a stock market crash, but the FX positions will escape unscathed. Remember that CFD traders also have great flexibility in going long and short – this means you can hedge your portfolio even when trading exclusively correlated assets, by mixing long and short positions within the same asset class.

Correlation during market stress

Diversification works whenever traders hold a basket of positions in uncorrelated assets. One problem that hits CFD stock traders is correlations that sometimes appear in special circumstances, for example during market crashes. When many traders panic and rotate out of equities, all stock prices tend to decline together, regardless of any previous lack of correlation, and stocks that previously showed little or no correlation suddenly approach 1. The best way to protect against this is to use positions in more than one asset class: although a major stock market crash will have impacts outside of the stock market, they will be complex, and FX positions are unlikely to show significant correlation.

Diversification and day trading

Diversification is most important for long term investors, and the principle originated in long-term equity investing. CFD day traders can’t just ignore it though, because there are still risks in portfolio concentration, or in unintentionally making the same trade with different assets due to correlation. When we open a CFD we are looking to share in the price action of a particular asset; what we don’t want to do is repeat that price action with multiple different trades. For example, a commodity-linked currency shares price action with its exported commodity, so being simultaneously long oil and the CAD or RUB is a double trade, one that will potentially cause problems should oil prices fall. The ideal trading portfolio includes a reasonable number of uncorrelated separate trades each following their own logic; that mean identifying markets with little in common and using uncorrelated assets to trade them.

Diversifying trading portfolios

Diversification protects traders from losses, assuming the positions are not correlated. Let’s say you divide your trading portfolio into 5 positions, each with 20% of your cash balance. This is obviously riskier than dividing it into 20 positions, each with 5% of the total balance. The odds of all of your positions failing are lower than one of them failing, but the effect of correlation can reduce or even reverse this. If the average correlation of all of your positions is 1 or more, there will be no protection from diversification. In practice this is unlikely, but it is still a good principle to try and trade in uncorrelated assets where possible, either by trading across asset classes or checking for uncorrelated assets within each class.

The easiest way CFD traders can apply an investment diversification strategy is by trading in different markets. Let’s say you commit to 5 positions on major FX pairs, 5 on stocks and ETFs, 5 in crypto, and 5 in commodities including precious metals. Following this strategy, it is likely you will have enough uncorrelated assets to protect from likely negative scenarios such as a stock market crash or currency devaluation. The problem is its easiest to trade in familiar markets, and since commodities ETFs have very different price characteristics to major pair FX this requires a broad understanding of different markets. One of the benefits of a thorough financial education is you will become comfortable trading in a broader range of markets, allowing you to benefit from non-correlated opportunities wherever they arise.

Conclusion

Portfolio diversification is important for CFD traders as well as for long term investors. Diversification in investing and trading follows the same principles, and the easiest way for CFD traders to benefit from it is to trade across asset classes, dividing their open trading positions into a reasonable number, avoiding overconcentration and avoiding trading multiple similar risks via correlated assets. Correlations between asset classes do exist, but due to the very different price action of bonds, stocks and forex (not to mention cryptocurrencies) they tend not to move in perfect lockstep, allowing you to benefit from a diversified portfolio. If you want to start testing out CFD trades in different markets to build a diversified trading portfolio, why not open a live or demo account today?

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