How to diversify your portfolio: Risk-management strategies

How holdings interact can affect overall risk and return

Note: Forex, CFDs and futures are complex instruments and can carry significant risk, often involving leverage. Losses can be substantial and, in some cases, may exceed the initial investment. They may not be suitable for all investors.

Let’s explain this with an example. You decide it's time to start trading. You understand that the value of your investments can go up and down. You start by buying shares in a few companies. You then decide to trade a currency pair as well as gain exposure to commodities.

Now, your portfolio has three types of exposure: shares, currency trading (forex) and commodities. Each type of exposure can be divided further. You can hold shares in different companies, trade different currency pairs, or gain exposure to commodities such as oil and gold through available instruments. For simplicity, let’s treat each type of exposure as distinct from the others.

Each investment is its own thing, but they’re also part of the same portfolio. This portfolio represents the total of your holdings and exposures. Therefore, even though each one is distinct, they all impact your total investment, just as each ingredient affects the taste of a cake.

Distinctions and connections matter 

These distinctions and connections matter. For example, let’s say your shares and currency positions are showing gains, but your commodity exposure is showing losses. In their own right, commodities are negative.

However, because these holdings and exposures sit within the same portfolio, gains in one area may partly offset losses in another.

This shows why diversification can matter. Your overall profit or loss reflects the combined performance of the holdings and exposures in your portfolio. So, while the definition of a portfolio is easy to understand, you need to understand the basics of diversification.

You need to understand the interplay between your investments and how they’re separate but also indirectly linked. Understanding these relationships can help you think more clearly about diversification.

What is a diverse portfolio? 

A diversified portfolio contains holdings across different assets, sectors, regions or markets. Going back to our previous example, a portfolio that contains stocks, forex and commodities is diverse because the investments cover different markets. It’s also possible to diversify within a single market. 

For example, you could invest in stocks but focus on different industries. You could have a selection of tech stocks, as well as stocks in energy companies, healthcare companies, and utility companies. These investments are stocks. 

By focusing on a variety of industries that aren’t directly linked, you’ve introduced an element of diversity into your portfolio. In practice, diversification can be applied across asset classes, sectors, geographies, currencies, investment styles, and time horizons. That’s the practical definition of diversification. On a theoretical level, diversification can also be defined as a risk-management tool.

So how can you use diversification to manage risk?

Reasons to diversify your portfolio

The main reason to diversify is to avoid making a portfolio depend too heavily on a single investment, sector, asset class, or country. When too much capital is concentrated in one area, a setback there can have a larger effect on overall performance. 

A second reason is that different investments may respond differently to the same market conditions. Shares, bonds, commodities, currencies and cash-like assets can be affected by interest rates, inflation, earnings and economic growth in different ways. When these exposures are combined, weakness in one part of the portfolio may be partly offset by stability or gains elsewhere.

Diversification can therefore help reduce concentration risk and make returns less dependent on a single source. It may also support a more balanced long-term approach because the portfolio is built around a mix of exposures rather than a single market view. 

However, diversification does not guarantee gains or prevent losses. During broad market downturns, many assets can decline simultaneously. Even so, spreading exposure across different areas may help reduce the impact of any one holding, sector or region on the portfolio as a whole. 

Four tips for creating a diverse portfolio 

When building a diverse portfolio, you can’t simply put money into a few assets and hope to make a profit. You need a strategy. So here are four tips to consider when you’re diversifying your portfolio: 

1. Look for distinct investments 

When you begin to create a diversified portfolio, the first thing you need to do is build a solid foundation. This foundation needs to contain a varied selection of asset classes. By varied we mean that the asset classes can’t be too closely correlated. 

It is possible to have a diverse portfolio of stocks, but look closely at the stocks you choose because the best way to diversify is to focus on a variety of markets.

One aim is to combine assets with lower or negative correlations where appropriate. When assets are less correlated, their prices may move differently, which can support diversification. When one asset is up, another could be down.

Of course, it would be ideal if all the assets were up in value. However, in the absence of this happening, you want to make sure that a bearish market for one asset doesn’t create a bearish market for other things in your portfolio. That can be difficult because many parts of the financial system are connected, and correlations can change over time.

For example, you could hold stocks in Microsoft and Apple. You could also have investments in oil and gold. These assets may behave differently in some market conditions, although their relationships are not fixed.

In reality, the price of gold, oil and equities can behave differently, but correlations can change—especially during market stress—so relationships are not reliable.

This is the thought process you should go through when you’re building a foundation for your portfolio. If several holdings are highly correlated, it may be useful to review whether the portfolio is less diversified than it appears. That’s not to say you can’t have investments with strong correlations in your portfolio. However, a portfolio dominated by highly correlated holdings may offer less diversification than expected. In general, lower correlations may improve diversification benefits, although they do not guarantee lower risk in all market conditions.

2. Think about costs and fees

Different assets incur different costs and fees. Fees vary by product, venue and account type; check the current fee schedule for the applicable charges.

As well as broker fees, you need to think about your total stake and the varying costs of each asset. Only you know what a realistic budget is. The general rule is that you shouldn’t invest money you can’t risk losing. Once you’ve got a figure in mind for your total investment, you need to think about how much you’re going to put into each market.

Again, this is a matter of personal preference. However, let’s say you’ve got USD 10,000 and you want to invest in stocks, forex and commodities. After reviewing your objectives and risk tolerance, one illustrative split might allocate 50% to shares, 30% to bonds and 20% to commodities. These percentages are examples only and not recommendations; allocations depend on individual objectives, risk tolerance, and product availability. These percentages could change over time. However, they can be used as a starting point. In this example, you would allocate USD 5,000 to shares, USD 3,000 to bonds and USD 2,000 to commodities.

3. Keep adding to your portfolio with dollar cost averaging

A portfolio can change over time as your goals, contributions and market conditions change. This is where dollar cost averaging can be useful. Dollar cost averaging is where you invest money into a portfolio over a sustained period. That means you don’t put all of your money into something at once.

For example, let’s say you’ve got USD 10,000 to invest. There are no rules against investing all of it at once. However, if you do this, you’ll have to take whatever the latest price is/prices are. It could be a good price; it could be a bad one. It’s impossible to know and you have to rely on the market moving in your favour.

With dollar cost averaging, you’d start by putting in a certain amount. Let’s say you invest USD 2,000 in stocks, forex and commodities. This leaves you with USD 8,000 to invest. From this point, you’d commit to investing the same amount over a specified time. Let’s say 10 months. That means you’d invest USD 800 into your portfolio every month for 10 months.

The price you’ll pay for each asset in your portfolio will vary over 10 months. Some months you’ll get better prices, some months you’ll get worse prices. This means you may spread entry points across different market prices over time, which can reduce reliance on a single entry point, but it does not guarantee better results or protect against losses.

This approach may help manage timing risk, but it does not ensure the best overall price. Investing and trading aren’t static events. They’re dynamic. Some investors periodically review whether their holdings still match their objectives and risk tolerance. Once a diversified portfolio is in place, regular contributions may be one way to build exposure over time, depending on affordability and objectives.

4. Don’t go on autopilot

There’s nothing wrong with holding long positions. However, in line with our previous point, you shouldn’t remain static. Investing in multiple assets and creating a diverse portfolio is the first step. It’s not the final step. You can’t go on autopilot and hope that your diverse range of investments will look after themselves.

Portfolios may be reviewed periodically to assess whether each position still fits your objectives, risk tolerance and target allocation. Rebalancing decisions depend on circumstances and can involve costs and tax considerations.

Building a diverse portfolio in practice

A diversified portfolio usually combines holdings across asset classes, sectors, regions or investment styles that are not all driven by the same risks. The aim is to reduce reliance on any single area, although diversification does not guarantee profits or prevent losses.

Investors may diversify in several ways, including broad-market funds, ETFs, bonds, shares across different sectors or regions, and other instruments where suitable. However, product choice should always depend on your personal objectives, risk tolerance, time horizon, costs, and your understanding of the risks involved.

Saxo’s demo account can help you familiarise yourself with the platform and practise placing trades in a simulated environment. However, demo conditions can differ from live trading, and any decision to invest real money should take into account affordability, product risk, fees, and the possibility of loss.

Finally, regular reviews can help you check whether your portfolio remains aligned with your objectives and risk tolerance.