A nice simple article on diversification. Taken from IBFX’s website.
We all hear diversification is the best policy for an overall investment portfolio. This is also true amongst our currency focused investments as well. We must master the use of multiple trading strategies and multiple currency pairs to equalize our overall return. There are many traders that utilize trading strategies that when trading conditions are met are 80% accurate. However a full-time trader must utilize more than this single strategy as many times there are long periods of time when the trading conditions are not met which can last from a few days to several months. What good is a single strategy that can yield profits only half the year. Diversification is the answer. The key to making a living from your trading profits is to master several strategies that together yield consistent profits month after month.
Diversifying your investment is not the most popular of investment topics. In fact many people believe diversifying dilutes trading profits. But most investment professionals agree that while it does not guarantee against a loss, diversification is the most important component to helping you reach your long-term financial goals while minimizing your risk. But, remember that no matter how much diversification you do, it can never reduce risk down to zero.
What do you need to have a well diversified portfolio? There are 3 main aspects to ensure the best diversification:
Your portfolio should be spread among many different trading strategies.
Your trades should vary in risk and time held. Picking different trade opportunities with different potential rates of return will ensure that large gains offset losses of other trades. Keep in mind that this doesn’t mean blindly place trades all across the spectrum!
Your currency pairs should vary by region and crosses, minimizing unsystematic risk to small groups of countries.
Another question people always ask is how many currency pairs they should trade to reduce the risk of their portfolio. The portfolio theory for stocks tells us that after 10-12 diversified stocks you are very close to optimal diversification. However in the currency market this doesn’t mean buying 12 currency pairs will give you optimal diversification, instead you need to trade currencies of different regions and importance levels (i.e. majors, crosses and more exotic currencies).