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Forex trading: How to handle Forex Portfolio Management with Diversification

Both portfolio management and diversification are relatively modern techniques that are used to minimize the risk in a given portfolio.

Modern portfolio theory attempts to spread or allocate investment over different assets using advanced mathematical techniques so that the downside in one asset is set off against the upside of another. This is possible in theory because when equities lose value, bonds gain and vice versa. Therefore a portfolio that contains both equities and bonds is less risky than portfolios that contain only equities or bonds.

Diversification is at the heart of modern portfolio management because it is the technique of actually mixing up investments in different asset classes in a portfolio.  Diversifications maybe simply described as a modern version of the old saying “don’t put all your eggs in one basket”. Again diversification can involve a lot of complicated mathematical techniques but we will try and describe diversification strategy in the simplest possible terms.

In commonsense terms, diversification can be achieved in the following ways:

-spreading the investment across different types of assets such as equities, bonds, real estate, forex trading, mutual funds and so on

-varying the risks in the investments. For instance you may choose to spread your investments in mutual funds across different classes such as exchange traded funds, actively managed funds, commodity funds and so on

-varying the risks by industry or by geography. For instance you can choose a mix of domestic and international investments or investments in a number of different industries.

You should keep in mind that because of diversification balances risks, there is often the chance that which you will not achieve the highest possible return on your portfolio.

It is also possible to use diversification techniques for specific asset classes such as a forex portfolio. Each currency pair has its unique pattern of behavior and many pairs tend to move in correlation. Consequently, the diversification strategy to be adopted is to minimize risk while maximizing profit that can be derived from the correlation. Because there are far fewer currency pairs available in comparison to say equities or bonds, which is actually easier to work out a sensible diversification strategy for forex. All that the forex trader really needs to do is select a few appropriate currency pairs.

Currency ManagementFor instance, the Euro and the GBP tend to move in the same direction against other currency pairs and make them a relatively low-risk trading option. You can also diversify economically because different economies are tied to different factors. For instance, the Australian dollar reflects movements in which commodities and the wool markets because of the importance to the Australian economy. The Swiss franc has some links with the movements of gold and silver prices because it is partially backed by both. The US dollar has strong links to oil prices because all international trade in the oil is denominated in US dollars. The US dollar also has a strong inverse correlation to the price of gold.

According to the best forex brokers,a common mistake that many beginners make is to take currency pairs that move in the same direction so that no real diversification is possible. They also failed to provide adequate weightage for volatility so that more weightage is given to the less volatile pair. When one pair moves 20 pips and the other pair moves only 10 in the same time period, the first pair should comprise one third of the basket while the other comprises two thirds.

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