Spread Betting: Diversification

We hear a lot about diversification in a portfolio, and sometimes it is misunderstood. Diversification is really just an aspect of asset allocation, which is how much of our funds we put in each of many directions. Spread betting, because of the leverage it allows, is an ideal financial vehicle for diversifying your account, and this applies whether you only spread bet, or your own equity in your portfolio too.

The benefits of a diversified portfolio will time and time again have proved their worth to the seasoned investor and trader. With volatile markets keeping the “risk on” mentality at bay, diversification is the one “free lunch” that allows market participants to mitigate risk without negating the overall return from their portfolio. Diversification helps to smooth out the wins and losses whilst creating the opportunity for riskier trades within the portfolio, and is integral to an easier, less-stressful trading environment.

Without going into detail, it is quite obvious that in general it is much safer to open several smaller trades in uncorrelated markets than to stake everything on a single spread bet. In fact some traders are of the opinion that you should treat your spread betting account like your own private hedge fund using it to gain exposure to a variety of financial markets in both directions using leverage, although you should still make sure that this follows certain risk management principles.  The idea of diversification is that any particular event, whether it is the banks crashing or energy soaring in price at signs of a shortage, will only affect your account in a small way. Your funds are placed in diverse directions that perform independently from each other. As an exercise, this is sometimes more difficult than it appears.

Firstly, it’s fairly obvious that if your trades or investments are in one market sector, then your account is not diversified. Say you split your funds between various financial houses and banks, on the basis that you expect them to perform better than the market in the next year, you could very well be right but you would not be diversified.

This points out one consequence of true diversification. It will never be as profitable as putting your money in the right industry for any time but the problem is that without adequate diversification,  if your prediction proves wrong, you could accumulate big losses fairly quickly.  Professional traders tend to specialise in one asset class, becoming say, a bond or forex trader, however such an approach is dangerous for private investors risking their own capital.  The assumption is that you won’t be right all the time in selecting the best industry, so inevitably sooner or later you will do worse than the market. Diversification is a type of insurance against a catastrophic loss, and in common with conventional insurance contracts, diversification will cost you some money. This is the price of being more secure in your holdings.

Secondly, many markets are interrelated and this correlation between asset classes makes it harder to achieve true diversification. A rise in energy costs is often associated with a fall in the shares of the airlines. The Nikkei 225 index is usually strong when the yen is weak. The Australian dollar and gold prices seem to go up and down together. Sometimes there are reasons for these relationships that can be understood, and other times they are just simply observations. But if prices are related, then the portfolio is not truly diversified. Even though in this case some relationships are inverse, diversification requires that as far as possible there is no relationship between the financial instruments.

Note the following points about diversification -:

  • It is good practice to hold both long and short positions as this reduces the risk should the wider market move sharply in one direction.
  • A well diversified portfolio consists of a number of positions such that no individual losing trade has the potential to affect the account in a big way.

Apart from spreading the risk, diversification provides different sources of income or capital growth. When one is doing well, another may be flagging, but on the whole the profits will average out to give a steady growth.

In the financial markets, there exist what one can call natural hedges. An example would be the USA dollar and commodities that trade in US$ dollars. There exists an inverse correlation between the price of, say, crude oil and the price of the USA dollar index; this is because the more expensive the dollar is, the most expensive it becomes for foreigners to buy such commodities and vice versa. For this reason if you have a big position in crude oil, you could hedge this by opening a long position on the USA dollar, as any fall in the price of crude oil is likely to translate into dollar gains. The fact that you have more than one type of investment, and your account is diversified, means that there will usually be a sector making good progress to make up for the laggard.

You may think that you do not want to be invested in each of the market sectors most of the time, as sometimes they are in a downtrend. With spread betting, this is no problem. You can still take a position in a sector but it would be a short position, expecting to profit from a loss in value in the index or share. So a well diversified and profitable portfolio is almost always attainable, but needs to be thoughtfully considered and you should only diversify in markets you are well familiar with. One obvious drawback of diversifying your account across multiple assets is that the more you split your assets into different markets, the more you risk losing your focus on proper research.

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