Diversification as defined by the American Heritage dictionary is: “To distribute (investments) among different companies or securities in order to limit losses in the event of a fall in a particular market or industry”. The primary goal of diversification is to “capitalize on returns” through investments in different areas so prevent a total wipe of your positions should the market turn against you. Nearly all investment specialists have the same opinion that, diversification is absolutely necessary to avoid risks for long-term investments.
Just imagine that you have an account in Forex, and you only trade the EUR/USD, can you diversify your position? The answer is YES. A very resounding yes at that as well! Even if you trade just one currency pair you still should diversify your holdings. In a while we will go through just how to do that. Let us first explore the advantages and disadvantages of diversification in Forex. One of the advantages of having a diverse holding would create more stability in your account. Just image if one trade turns against you (which is highly likely) you have at least some other trades that would win. Thus your final profit and loss statements for a day will show a profit. If you had just one trade most likely you would be facing with a loss for the day.
A disadvantage of diversification is that there is the possibility that you get carried away and over diversify your positions. Focus is needed to maintain profitability in your account, an over diversification will dilute that focus which makes it difficult to grow your account. To illustrate the above 2 examples let’s work through some figures: For instance you fund your account with $10,000 and each position size you take is normally 5% of your total account. How should you diversify your account? There are three ways of diversifying and I recommend that you do at least two.
First method is that you break your 5% into 1% each and trade with 1% per trade instead of a huge 5% in a single trade.
Second is that you trade different time frames, for instance you normally trade 5 minutes, now have two position one 5 the other 15 minutes. Third, you can trade non related currency pairs. For example The EUR/JYP and the GBP/USD Based on your money management rules, use at least 2 of the above 3 points to help you diversify your positions.
Next we have to address the issue of over diversification. It can be a potential problem if you lose focus and over diversify. As the old saying goes, “too many cooks spoil the broth” over diversification is like that. I would suggest that you should have no more then 3 positions opened at any point in time. For example, you decided to use 5% of your account to trade and instead of having in all in one trade, you slit it up into 2 different trades with 2 pairs. You use 2.5% to trade the EUR/JPY and the next 2.5% to trade GBP/USD. This spreads out you risk a fair amount. You can still focus on these two trades and if thing go well you will earn on both. If one fails there is a chance that the other will win.
There is that possibility that both trades turn against you. That’s why at the onset you only use no more than 5% of your account to trade! Diversification is a part of good money management; it will protect your account and help you make more money in the long term.