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I often say that risk control is one of the most important things that a trader can learn. We see a lot of talk about stops and position sizing but it almost seems like forex investors feel like diversification is either a bad idea or not possible for a currency trader. 

What you will learn.

- Asset class diversification means investing inside and outside the forex

- Diversifying your strategies within the forex can help smooth returns

- Many dealers/brokers offer other asset classes within the same account

- It is possible to be diversified and trade actively at the same time

There are two ways to look at asset allocation and diversification. The first is to make sure you are not exclusively invested in a single asset class. For example, being solely invested in the forex or stocks or bonds leaves you exposed to systemic risk. Systemic risk is the type of risk that you can’t get rid of. Systemic risk covers anything from your account being frozen through insolvency to catastrophic volatility in a particular market because of an unexpected unknown.

The second way to take advantage of diversification is by creating variety in the way that you trade or invest within an asset class. For example, if you are managing your forex positions one trade at a time, or with only a single strategy, you are exposing yourself to focused risks without any way to offset them. This creates volatility within your account, and account volatility can mess with your trading mentality.

Here are a few simple ways to start building a diversification strategy. You will find some example allocation ideas in this lesson and a little more detail in the video.

Asset class diversification

Usually investors will try to spread their risk into other asset classes. The benefit is that when one market is not performing well, another market may be doing much better, and the combined return is much smoother. For example, owning or trading bonds while some of your money is in the forex and/or equities can smooth your overall returns.

When we talk about asset-class diversification, there is a misconception that this would not be helpful for investors that are actively trading the market using a short-term time frame. That is incorrect. In fact, asset class diversification, regardless of your trading timeframe, has the following benefits:

- It spreads risk across a larger pool of investments

- It creates an awareness of the whole financial market

As a forex trader, you know that changes in equity or commodity prices may impact your forex trades and could create trading opportunities. Being active in those other markets can help create an innate awareness of what market forces are at play in the forex market.

Here is a sample asset-allocation strategy. The percentages can obviously be changed to suit your own investment preferences, but hopefully this will give you a starting place for some ideas.

- 25% Equities: Could be the SPDRs (Spiders) or an equity-market futures contract

- 20% Cash and equivalents: Cash is king, and in a pinch, 90-day treasuries can be even better

- 25% Forex strategies: Long-term and short-term trading/investing strategies

- 30% Fixed income / bonds: ETFs or managed funds can be a great alternative and can be leveraged.

In the video, we will cover a few specific ideas but you can explore on your own to see why even professional managers will allocate their risk across markets.

Strategy Diversification

While investing in one trade at a time is where a lot of new traders will start, doing so may inadvertently expose you to a very concentrated level of systemic risk. We look at strategy diversification as a mix of long-term and short-term opportunities. Some strategies that could be used are long-term and diversified within themselves already. We have some strategy groups illustrating a few examples of those ideas on the PFXGlobal.com website. Even within the portion of your portfolio that you have set aside for active trading, you can benefit by adhering to the following tips for avoiding too much systemic risk:

Consider using consistent position sizing when planning your trade

Using the same currency in too many pairs may increase your risk exposure

Neutralize the USD, EUR and JPY by mixing the crosses into your trading

Learn to hedge with options or manage your risk with adequate stops

Video Archives

For a larger version of the video, right click and select the full screen option.