What level of diversification are you using?

Diversification, of course, is about taking positions in markets or securities which have low or negative correlations to reduce total portfolio risk. Basically, you're looking to have positions which aren't likely to all trade in the same direction.

Diversification has been a major talking point in recent years among money managers and academic researchers. This is because of the way the major financial markets have all been highly correlated during times of crisis – as witnessed by the so-called "risk-on" and "risk-off" trading patterns we've see in the markets.

This chart shows a rolling 12-week correlation of returns comparing the S&P 500 with four major markets (GLD = gold ETF, TLT = US long-term Treasury ETF, HQD = US high grade corporate bond ETF). A reading above zero is a positive correlation, meaning the markets move in the same direction. A reading below zero is a negative correlation, indicating markets that move in opposite directions. The more the reading moves toward 1 (-1), the more the return of the two markets match (are the inverse of) each other.

As you can see, the correlations do change over time – quite considerably and quite rapidly in some cases. Those quick changes, often coming all at the same time across markets, are often the function of extremes in market psychology, one way or another.

Is there a way to avoid these dangerous swings? I think there just might be, by taking diversification to the next level. That means going beyond just allocating funds among different markets. It's diversifying among trading strategies as one can do with the Trade Leaders program. That level of diversification, done properly, can make the market allocation just about irrelevant. My analysis shows that this can produce very low cross-market correlations. Watch this blog for fore information about how low it can go.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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