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Portfolio Diversification with Limited Capital

by Soft2share.com

Even a casual investor knows that the more diversified a portfolio is, the greater the opportunity to make profits in any economic climate and lower risk from being over exposed in a single area. While diversification can be defined in many different ways, it is very difficult to achieve for small investors effectively. If your investment capital available is only in the thousands or tens of thousands, it is not possible to be fully diversified in many sectors as an individual using conventional investing tools. True diversification means exposure in stocks, bonds, and commodities at the bare minimum and really should include currencies and real estate as well.

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The funds invested in the Forex will protect against losses in an individual economy or inflation in the home currency of the investor, commodities such as gold typically increase in value if currencies depreciate as a further hedge against inflation, stocks and bonds offer the ability to get earnings through both capital gains growth and dividends, etc. This multi-layer diversification means the investor has the ability to make profits at all times. The problem for many is, with limited capital the only option is to choose mutual funds that invest in a variety of sectors or several specialized funds, one in each sector. While this is a common approach, the high fees in funds for management make it so significant gains in a market yield relatively low not gains to the fund investor and even small losses are large once the fees are added to the loss.

There are methods readily available for even small investors to take positions in markets that traditionally require extensive capitalization to enter. Most of these methods involve investing in market results as opposed to the actual market. You get to make profits (or take losses) at the exact same rate as the index or individual commodity, but do not need to actually buy or own the shares or the commodity invested in. Adding to the potential profit (and equally to the risk) is the fact these methods of investing typically allow the use of leverage.

Leverage simply means you need only a small amount of money to invest, but a brokerage takes a position on your behalf for a much larger sum. In the Forex market as an example where almost all transactions are leveraged, it is not difficult to find a brokerage that will offer leverage of 100x. This means your $1000 investment allows you to take the same position of somebody actually buying up $100,000 in currency. Suddenly your limited capital has the same power of a very large portfolio.

In the commodities market a common tools used in many parts of the world (it is not offered in the US, US would need to utilize offshore brokers or accounts) is the Contract for Difference (CFD). This investment tool is a contract between you and the broker that allows you to make contract trades that have the same value as the underlying product but with very low capital investment. In this case your investment is called the margin, and these instruments have the same risk/reward of any margin call. There are fee structures that very by brokerage for providing the CFDs but it is a way for small investors to diversify into the commodity market (albeit a high risk method).

As an example for the commodities market (using sample numbers- margins and terms of contracts vary from broker to broker), gold ended trading today at $1391 an ounce. For $1000 (less than a single ounce of gold) an investor can purchase a CFD that is based on a contract unit of 100 troy ounces. You would need$139,100 to buy 100oz of gold as a commodity to sell on the commodities market, but with $1000 margin you can take the same position on a CFD. To make it more interesting, you can take the position in a CFD if you think gold will increase in value (a sell position) or decrease (a buy position). If you expect an increase in gold and take a sell position on your 100 oz contract and the price of gold goes to $1400 and you close your contract, there is a $9 profit per ounce x 100 = $900. You made a $900 profit on a 1 day, $1000 investment. There would be fees but on a typical contract those would be in the $50 range. This allowed the same profit opportunity as a person actually buying the gold for $139,100.

The other side to this coin is simple as well. If the market would have dropped and you wanted to divest you would have lost $900 plus your fees, so your entire investment is gone equally as quick. That is not the downside however. The down side is, it the market would have dropped $15 dollar in that day (as it did yesterday) you would been required to immediately add $600 to you margin to cover the loss and selling you have lost not only the $1000 invested, but an additional $600 you never planned to invest. This is the downside of margin calls compared to actual commodity trades.

Actual CFD have more parameters, with limits and stops that can be added and other features as well, but it makes clear the risk reward structure, and the availability of entering alternative markets with small capital investments. It is certainly worth learning about if you want to diversify however it is something that needs a very considered approach as the risks are substantial.

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