Anyone that has been trading for a long time has heard that diversification is the only free lunch our there, referring to the economics principle that nothing good is free. The problem has been that if you went to the typical financial planner you were deworsified and not diversified. Dont worry because diversification is still very useful if done properly and really does help to increase returns and lower risks.

The typical planner will have you put some of your money in domestic stocks, some in foreign stocks, and then place some money in bonds. If that is all you are doing you are not getting nearly the benefit you could be getting and in reality you are barely diversified at all.

When you are properly diversified you will be invested in all liquid asset classes and sometimes even a few that are relatively illiquid investments. In addition to being in several asset classes you will also be in several different types of strategies with multiple time horizons. Global macro traders have known for years that if you dont cast your net wide you will have a hard time performing in all market types. If you just have a bunch of global stocks then all your investments are extremely correlated which means when a few drop the rest drop. One of our goals as investors is to avoid that.

Global macro traders diversify into asset classes such as domestic stocks, foreign stocks, Treasury bonds, investment grade corporate bonds, junk bonds, foreign government bonds, foreign corporate bonds, commodities, real estate, and currencies. Some traders even trade in collectibles like art. Why do they cast their investment net so wide? For the simple reason that one asset class may be in or out of favor at any given time.

One of the best known although regularly ignored tenets of successful investing is to look for the best risk to reward situations. If you dont focus on risk then it will come back to haunt you and cause you to lose lots of money. By looking across multiple asset classes you will be better able to find great risk to reward scenarios as not every asset class is always in a good position to make you money.

As previously mentioned we can diversify not only by investing in several asset classes but also by investing in strategies with different time horizons. There are successful long term and short term trading funds and if you invest in both you are even more diversified as their returns depend on different factors.

If you do this properly and diversify into not only different assets but also into different strategies inside each asset class you will be able to capture returns that the classis stock bond mix would have missed. While this is no guarantee of positive returns every day, over time you will see a reduction in risk and an increase in reward. Diversification is really a free lunch.

If you prefer to do all of this on your own then you will be well served to learn how to build or just buy several good models so that you can more easily track several asset classes. For instance you will want a few models for the stock market, a few for commodities, etc. The more efficient you set up the process the better your returns will be as you will miss less great risk to reward opportunities.