For this post, I want to visually demonstrate the benefits of diversification by examining the back-tested returns of the exact same simple strategy on 4 different pairs compared to trading the same strategy across all pairs at the same time. Please note that past performance is no indication of future results.

Most retail FX/CFD traders concentrate their risk in 1 or 2 instruments. This can lead to devastating effects to your portfolio if you get caught on the wrong side of an unexpected large gap in the market. It can also lead to very volatile trading performance which may cause burnout or lead to excessive risk taking to increase returns.

Lack of diversification also means that you’re restricting your trading opportunities to just the instruments that you trade. A trader who was just trading EUR/USD with this strategy could have some serious underperformance compared to other markets.

In addition to this, the charts below suggest that diversification can potentially improve your overall results by increasing your Sharpe and MAR Ratios. The MAR ratio gets its name from the Managed Accounts Report newsletter and is calculated by dividing the compound annual growth rate (CAGR) by the maximum historical drawdown.

The Sharpe ratio is a way to measure risk adjusted returns that most are familiar with. I prefer to focus on the MAR ratio as it’s a good measure of gain/pain.

For the results below, the same exact strategy parameters were utilized for each back-test as I’m not here to advocate a particular strategy.

Keep a close eye on the CAGR, MAR, Max Total Equity DD (drawdown) and Annual Sharpe ratios in each of the back-tests below.

EURUSD only

Examining the Benefits of DiversificationExamining the Benefits of Diversification

Images created using Trading Blox software.

USDJPY Only

Examining the Benefits of DiversificationExamining the Benefits of Diversification

Images created using Trading Blox software.

EURJPY Only

Examining the Benefits of DiversificationExamining the Benefits of Diversification

Images created using Trading Blox software.

GBPJPY Only

Examining the Benefits of DiversificationExamining the Benefits of Diversification

Images created using Trading Blox software.

The best MAR ratio for trading just one pair is on USD/JPY, which has a CAGR of 11.61% and Max DD of 29.9%.

You could try to increase returns by increasing your risk per trade, but your Max DD will increase just the same. What do you do if USD/JPY encounters tough market conditions similar to results seen with EUR/USD?

Let’s see what happens in our backtest when we combine EUR/JPY, GBP/JPY, and USD/JPY:

Examining the Benefits of DiversificationExamining the Benefits of Diversification

Images created using Trading Blox software.

When you combine 3 pairs, the CAGR improves by almost 3X and the MAR ratio doubles compared to the results for trading just USD/JPY.

What do you think happens when we include EUR/USD as well? The backtests for that strategy weren’t that great:

Examining the Benefits of DiversificationExamining the Benefits of Diversification

Images created using Trading Blox software.

Surprised?

Including the less than stellar results of EUR/USD actually increases the CAGR on the results for all 4 pairs by over 7% compared to the results for just 3 pairs and the MAR ratio improves to .86 from .78.

Also, notice that the strategy for EUR/USD only produced a CAGR of 3.21% by itself, yet when combined with the other pairs, the overall portfolio level benefits of increased diversification become clear.

In summary, you can see that the Sharpe and MAR ratios improved when all pairs in the same strategy were added.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES IS MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION.

OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.