Trading on the eToro platform offers multiple great opportunities but there is always some risk involved in doing so. Markets and asset prices are very volatile and move constantly, not always in the direction you are hoping for and that is the inherent problem that exists in trading. This market instability may make you consider diversification as a possibly strategies in creating your trading portfolio as one of the ways to manage risks. Let’s have a look at what it is and how we can implement it on the platform.
(NOTE: Before we continue, we have to give a disclaimer that the trading products offered by the companies listed on this website carry a high level of risk and can result in the loss of all your funds. CFDs are complicated instruments that are never guaranteed to provide you supplemental earnings. In fact, Around 67% of all retail investors experienced a loss while trading CFDs. Make sure to keep this in mind before attempting to use the eToro platform yourself. All the information found on this website is not official trading advice and all practices shown are referenced for the use of the Demo account only.)
What is diversification?
Diversification is a strategy that helps you to manage the overall risk of an asset portfolio. In simple terms it means investing into more than one asset class (like stocks, bonds, commodities), multiple issuers of securities (for example, different companies that issue stocks) as well as more than one industry (technological, medical, construction sectors etc). Preferrably all of these should not be correlated with each other so that prices do not move in the same patters. In this way of investing into more than one asset and areas, if one of them faces a downturn or any other negative impact the rest of the portfolio is not affected in the same way. Essentially we are trying to ensure that prices of these different assets in a portfolio are not moving together so the impact of economic or company specific events affects only some of these assets but not all.
As a very simple example, let’s say you have a portfolio consisting of stocks of 3 different companies, some indices and a few commodities. If one of the stock issuing companies goes bankrupt or performs poortly, you may end up loosing on one of the 3 stocks and not the rest of the assets in the portfolio. As a different example, say that you have invested into 3 different companies from 3 different industries, the airline sector being one of them. Then in case of an event like a global pandemic, the airline sector may end up in losses while the other two would not be affected as badly.
Many times portfolio diversification is used in long-term investment and it is not a strategy you would use to obtain high returns quickly. The reasoning behind this is that in the long-term the addition of various types of assets helps in making higher returns with a risk that is on average lower than the risk of any of the individual instruments in the portfolio. That is the essence of diversification.
Do not forget that diversification is merely a risk managment strategy and does not guarantee absolute results; any trading involves risks of capital losses.
Risks of an Investment
To understand the workings of diversification we need to understand what kinds of risks we are talking about exactly. Generally each security faces 2 types of risks: systematic and unsystematic. Systematic risk, also known as the market risk or simply volatility is the risk that can impact the entire market and not just any single asset or industry. What could cause this kind of a risk? Well any major events or changes actually, such as recessions, sudden inflation or interest rate changes or even wars and revolutions. The recession of 2008 is a great example of such an event which dramatically changed asset prices and values of investments in multiple ways. What is the market itself made of? It is the collection of all financial instruments available for trading; many times the US S&P500 is used as a benchmark for market as whole as it contains 500 most influential firms of the country from multiple sectors. As you can see from the image below it is quite volatile and moves quide drastically both upwards and downwards.
It is nearly impossible to avoid the impact of systematic risk as it is hard to predict, but diversification does help to manage it to some extent. This is because of globalization which makes financial markets across the globe interlinked. If there is a crisis in the EU for example, it is likely to impact the USA markets too, but probably to a lesser extent. There is a way to determine the degree of systematic risk of each asset and that is determening its beta, a numeric measure of sensitivity of a security’s price changes to changes in the overall market, but that is perhaps for a different topic.
The more important goal of diversification is eliminating unsystematic risk. Unsystematic risk is the complete opposite of market risk and refers to the risk of each specific asset or industry. That is the risk which can be diversified away to a large extent by combining many different assets or industries in a single portfolio. What are the causes of systematic risk? Well those come from the negative actions of the company or entity that issues the security, so for example a loss of sales or market share if we are talking about a company issuing stock.
As a simple example, if you hold a portfolio of stocks of different companies, if one of the firms does badly because of bad management, you should be able to compensate your losses from that firm with return from the remaining companies. That is the purpose of diversification.
One of the most important concepts in diversification is correlation of assets: the degree to which prices move alongside each other. Adding stocks from different companies but in the same industry (for example, the IT, medical or automobile sector) would probably make these assets highly correlated: if the industry as a whole faces a downturn, all of these companies are likely to be affected. What you may consider instead then is choosing instruments of different origin to make sure their prices are not affected in the same way.
Optimal Diversification on eToro
The process of diversifying in the best way can be quite complex and there is no simple ready-made solution for that. There are a few general things you might consider still:
1.Consider different assets like Funds and Bonds. eToro offers a more than 250 exchange traded funds covering all different types of markets worldwide. Funds themselves combine a collection of various securities, stocks, bonds and commodities and are a relatively good diversification tool. Many funds themselves thace an index (hence, Index funds) of a financial market with a passive investment strategy.
2.Monitor and update your portfolio frequently. This may be quite basic but constant monitoring and possible addition of new assets is one of the ways to ensure your portfolio is well diversified and up to date. That also involves exiting positions or even markets when necessary to avoid large losses beyond the acceptable level and the stop-loss function on eToro is a great tool to assist you in that.
3.Spread your investment across more than one asset. As the first section of the article hopefully showed, spreading portfolio into more than one asset and industry spreads the risk of your investment accordingly. Focusing on one asset or industry only exposes you to instrument-specific risks.
Disadvantages of diversification
As you have hopefully seen, diversification offers many advantages and mitigating systematic risk is certainly the most important one. However there are drawbacks too of course. Holding a wide selection of assets in a single portfolio may make it quite difficult and time consuming to manage and rebalance if necessary. Depending on the assets you choose on the platform there may be some transaction fees or commissions applicable.
Can we use diversification while trading with CopyTrading too? Certainly.
Many CopyTraders themselves attempt to reduce their risk ranking through diversification and add a wide variety of assets into their trading portfolios. You can always observe the composition of each trader’s portfolio as well as their strategy in trader’s bio and statistics and decide whether their diversification is sufficient and suitable for your preferences. There is always an option of investing into more than one CopyTrader or combining your own portfolio of assets with an investment into one or several CopyTraders. Thankfully the options on the eToro platform are multiple.
Well, how can you diversify with CopyTrading? Here are some of the things you might want to consider:
1. Finding traders from different markets. Many investors looking for a trader to copy focus on their performance overview and not the portfolio composition and the type of market they are investing into. You can always look for CopyTraders that invest into various markets and industries as a possible option or combine several with more narrow focuses.
2. Looking beyond your usual choices. There may be certain markets or assets you are more familiar with than others which is perfectly understandable as one cannot possibly know everything. Other markets may appear more difficult for you to trade on your own while certain Copy traders may have a better understanding and strategies in these markets for you to trade in more easily. Perhaps considering other countries can also be a possibility.
3. Looking carefully at each trader’s statistics. There are many tools available for you to assess the chosen copy traders. The portfolio overview for example provides you with 3 tabs showing the exposure, risks and asset allocation within the investment. The CopyTrader below for example focused mostly on stocks as their investment.
4. Consider new markets and assets. There are many diversification options available on eToro already but the platform constantly adds on additional instruments and markets. That is something you can also consider while adjusting your portfolio.
5. Diversify based on trading styles and strategies. Many focus on diversification of assets and industries only and many time forget that traders use very different trading strategies on the platform too. Focusing on traders with the same or very similar trading strategies exposes your portfolio to the same strategy risk and if it fails you may be exposed to large losses. There is also an option to diversify based on the risk rank of traders, combining those with a longer term outlook and lower returns with perhaps more risky short-term investors. The options are numerous for you to choose from.
The great possibility for you to try in diversifying your portfolio is the available demo account where you can try to combine multiple assets or follow different CopyTraders to see if that works out for you.
As you have hopefully seen diversification is one of the most common risk managing strategies on eToro. Splitting your total investment across multiple different assets and industries reduces exposure to negative changes in each specific instrument. There are many ways for you to combine your own diversified portfolio fully suitable to personal preferences but there is also an option to diversify using eToro CopyTrader. Remember that any investment is always a risk and you may end up with loosing capital in doing so. Best of luck and enjoy trading on eToro!
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