Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio.
To remain successful in the business of forex trading regardless of all kinds of changes in market dynamics, one needs to clearly understand the concept of risk and apply it effectively.
The main reason why the majority of the traders eventually fail to be profitable in the long run is that they take the importance of risk management too lightly. Many of them take too much or too little risk because their definitions of risk are unclear and subjectively based on emotional conditioning.
There are few main misconceptions about some important aspects of RM, such as diversification, drawdowns, and position sizing. However, to implement a correct and adequate level of risk, one must clearly understand what each of these aspects can contribute to building an effective RM strategy.
For many traders, diversifications simply mean entering multiple positions involving multiple currency pairs at the same time. Conventionally, we have been told that diversification is supposed to reduce risk exposure. As such, most amateur traders, for the sake of diversifying, trade dozens of different currency pairs simultaneously, and they end up sinking faster due to over-diversification. Because they often do not realize that diversification achieves its risk-reducing benefits only if there is little correlation between the pairs one trades on.
For example, let’s say you risk 1% of your account per trade, and you decide to go EUR/USD and AUD/USD short and USD/JPY long. In this case, you are increasing your risk exposure because USD value somewhat plays an important role in the success or failure of all these three trades as all of them are involved with USD.
In fact, for the trades to be profitable, USD has to appreciate against the EUR, AUD, and JPY. Therefore technically, your risk level is no longer 1%. However, all three could go against you if there is a strong increase in the USD value.
To sum up, diversification will only reduce your risk exposure if it is implemented correctly. In fact, if currency pairs are not well-diversified, diversification could increase your risk level significantly. Thus, it is important not to trade the same currency more than once, but if you do, adjust your risk level per each trade involving the same currency accordingly.