What is diversification? While more commonly associated with long-term investing, diversification concepts also have benefits for short-term traders. This session covers economic, corporate, political and other developments that have an impact on different markets.
Video transcript
Taking advantage of moves in different markets can be just as important for traders as it is for long-term investors. That's why I'm here today to talk about the benefits of diversification if you're in trading.
Often when people think about diversification, they're usually thinking about longer term investments. However, the concepts of diversification can also be important for people with more shorter term orientation for professional traders as well. First of all, there's the idea of not putting all of your eggs in one basket. It's very important for traders to be looking at different markets so that if one trade goes against you, in one market, something else may work out and make up for it.
Different markets also react differently to news events so you may find that when a news event comes out, some markets may view it as favourably while others may view it as negative. In addition, diversifying allows you to take advantage of the research and analysis that you do when picking trades. Often times when figuring out a trade to put on, you may find trades that you want to be long in and at the same time, you may find markets that you wish to avoid or to be short in.
There are a number of different markets or asset classes that traders have access to. Moving from the smallest to the largest, we have commodities which include resources such as crude oil or grain such as wheat and metals. Second is the traditional stock markets around the world which can also include individual stocks as well as indices. Third is treasuries which is the government bond market and fourth is foreign exchange which are world currencies.
Markets can be divided essentially into four major groups which responds similarly to different trends. The first group is the interest sensitive group. These are areas that tend to go up when interest rates are going down and tend to go down when interest rates are going up. They include financial services stocks, utility stocks, telecommunication stocks plus bonds in treasuries.
Defensives are areas that tend to attract capital when people are worried about risk. In stocks, this includes the health care and consumer staples areas. In currencies, this includes the US dollar, the Japanese Yen, plus gold and silver.
The third group is the economically sensitive group. These are areas that tend to go up and down with the global economy. In the case of stocks, this is industrial companies and consumer discretionary companies. In the case of currencies, it's usually a major currency such as the Euro and the Pound. And also this group includes most commodities including crude oil, copper, wheat and a number of other major commodities.
The final group is the commodity in capital spending sensitive group, also known as the late stage sectors. These markets tend to lag behind the economic cycle a little bit, peaking later and bottoming out later. In stocks, this includes the technology group plus energy and materials. In currencies, it includes the resource currency group such as the Australian dollar, the Canadian dollar, New Zealand dollar, Norwegian Krona and the Swedish Krona.
There are a number of factors that influence trading and influence market prices. These different factors can have a different impact on different markets depending on what you're trading. The first one is the economic cycle and economic news, whether it's GDP or employment. Political developments can also have a significant impact on market. In addition to political risk, financial risk can also play a major role in driving market sentiment. Interest rate trends are also important for markets in terms of whether Central banks are tightening monetary policy or easing monetary policy.
The Portfolio Mixer feature on our trading platform makes it easy to track and back test strategies involving trading instruments across a number of different asset classes. On my own screen, I track the Euro/US dollar, West Texas crude oil, the US 30 and gold, and evaluate how they perform into various features, perform against each other. There's two ways of doing this. First of all, you can use a line graph which highlights how each of them have done over the last few months. In this particular case, I've used a 3-month time frame.
Over the last three months, crude oil has outperformed quite significantly and been the strongest of the group. The US 30 started out fairly slow, but has improved overtime. Gold started out reasonably strong, but had weakened through the middle of this period, and then has started to strengthen a gain of late. And finally, the Euro has generally under performed through most of this period.
So looking now at our summary, as an example shows that as the number of these instruments through the last few months had under performed and had a performance of less than zero or in other words, they lost money, generally speaking, a portfolio of being along 25% of each of these would have generated losses for most of the period. However, if we make a few changes to the portfolio, you can see that you have a room for improvement. For example, if we change the Euro/US dollar and made it, a went short instead of long, you can see what actually had been profitable for most of this period of time. And also, if you had been short in gold, you would have not only been profitable or quite profitable through most of this period, although your profits would have weakened a little bit more recently.
With the Portfolio Mixer, you can also look at changing various weights. Initially, we defaulted to a 25% trading of your portfolio in each of these. However, for example, if there's something you're more confident in staying in gold trade, you may move that up to 30 or 33 or 35 percent. And then that brings the other ones back down and you may decide crude or you want to do increase up to 30% as well. Also gives an example of how you can change the mix and the volatility and the performance of your portfolio across asset classes.
