Diversification is one of the best ways to reduce risk in a portfolio, and using different assets is one of the most effective ways to achieve diversification.
The idea behind diversification is relatively straightforward. By diversifying your assets into different buckets, which can range from anything to property, bonds and stocks in different sectors and markets, reducing the chance of failure in one part of your portfolio will dramatically impact your wealth.
Most investors diversify their portfolios by acquiring a range of different securities in different markets and different sectors. They can also own a range of different funds, owning different assets, such as bonds and equities and different markets. Many investment funds invest in pools of different stocks. In some cases, there’s a portfolio of more than 100 different equities in a fund (sometimes, funds can hold thousands of different stocks).
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In some respects, this automatically achieves diversification. However, it’s generally best practice to hold a couple of funds, each of which may have its own diversification policies to truly achieve the benefits of using different managers.
It may also be sensible to look outside of the world of equities to improve diversification in a portfolio. One of the best ways of doing that is to look to contracts for difference (CfDs) and spread bets.
Alternative products
These products allow investors to build exposure to different asset classes they may not necessarily have access to traditionally. CfDs and spread bets are derivatives, which means their value is attached to the price of an underlying security, and they do not give investors or traders any ownership in the underlying security. They are synthetic instruments managed and provided by financial services firms.
This means they are designed to be as accessible as possible for investors. For example, if you want to place a bet on the value of oil, you would need hundreds of thousands or even millions of pounds to buy oil futures contracts. Futures contracts are directly linked to the commodity and are used by traders to buy barrels of oil and hedge their exposure to the price of oil if they have a cargo or shipment of the commodity in transit. A futures contract commits a trader to take delivery of a certain amount of the commodity linked to the contract at a specific point in future.
Clearly, most individual investors don’t want to take on this liability. They don’t have the financial firepower or the resources to take ownership of barrels of oil if the contract should expire before they manage to sell it. That’s where spread bets and CfDs come into play. As derivatives, these products allow investors to trade underlying commodity markets with relatively small amounts of money, although traders can use leverage to magnify their exposure. This comes with its own set of risks and challenges.
Improving diversification
Using a spread bet to build exposure to oil prices is a great example of how investors and traders could use these products to enhance diversification in their portfolios. If you have a large position in a company like Royal Dutch Shell and you’re worried about the price of oil dropping over the next six months, you can go short on oil by using a spread bet. This way, if the price of Shell drops due to low oil prices, you have hedged out your losses.
There are plenty of ways investors and traders can use these derivatives to enhance diversification in their portfolios and improve returns over the long term while also reducing volatility.
For example, you could use a spread bet to hedge your exposure to certain currencies. This would reduce the impact of currency volatility in your portfolio. You could also take a leveraged bet in other international markets, markets you think may benefit from faster economic growth than may exist in home countries.
All of these strategies will come with risks as, after all, these derivatives are leveraged instruments and can enhance losses as well as magnify profits.
So it’s sensible to do your research first, and you should only ever enter a trade if you really understand the risks involved.
Nevertheless, by using derivatives such as spread bets and CfDs, you can improve diversification in your portfolio and ultimately reduce volatility. However, you should only use these tools if you have a solid trading plan in place and have considered all the potential risks as well as the rewards before building a position.
Your capital is at risk. 69% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you can afford to take the high risk of losing your money.
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