Portfolio diversification: what is it?
If you are a novice investor, then you have probably heard about what diversification of an investment portfolio is. It helps to reduce losses during the fall in the cost of some resources and benefit from others. Let’s talk about how to use this tool.
When it comes to building the best investment portfolio, you often hear that diversification is key. But what does that even mean—and why bother with it at all? After all, you already have a large number of stocks that are skyrocketing at the moment: Amazon, Apple, and eBay, for example. What can go wrong?
If you rely on a portfolio filled with big tech stocks and are confident that you will live off the income generated by your investments in retirement, you may be in for a surprise during the next downturn in the market. When the market is overvalued, it is easy for us to pick the “right" stocks, but when there is a correction, some investors regret that their portfolio is not diversified enough.
Portfolio diversification: what is it in simple words?
Have you ever heard the saying, "Don’t put all your eggs in one basket"? The same principle encourages investors to diversify their money. In this case, you distribute them among different investment options, thereby reducing the risk that you will lose all your money.
For example, when you diversify, you put some of your money into riskier trading and some into safer bonds. The main idea is not to rely on one type of investment. If you lose money because of some investments, others are your lifeline and compensate for the losses, providing a profit.
Diversification is important because its absence increases risk, and its implementation helps balance market downturns. Keep in mind that it is not enough to distribute money only between different companies. Collect portfolios from different areas, countries, types of investments.
Main types of diversification:
- Currency – is aimed at the use of money in different currencies. For example, when you keep money not only in 🪙, but also in euros, dollars.
- Instrumental – is aimed at dividing capital between different asset classes: stocks, futures, securities, etc.
- Institutional – you distribute money between different companies. For example, you have deposits in different banks.
- Transit – you withdraw profit from assets in different ways.
- Specific – in this case, the capital is distributed between different areas of activity: they invest in shares, real estate, businesses, etc.
Diversification by age
Distribution of investments is important at any age, but in some years you can afford riskier options, while in others you can choose safer ones. So, the younger a person is, the more risky a portfolio he can afford: the older you are, the more difficult it is for you to recover from financial shocks. The rule is simple: subtract your age from 100. This is the percentage of money you can invest in riskier ventures.
For example, when you are 20, you can hold 80% of high-risk stocks and 20% of “safe” investments such as bonds, while a 40-year-old investor invests 60% of the budget in stocks and 40% in “safe” investments.
Division by assets
It is portfolio diversification by assets that allows you to even out the financial situation during an economic downturn. Distribution options include:
- Stocks that often generate the most revenue either through price appreciation or dividends. They grow after crises, during periods of economic growth. If the market falls, you can buy more shares, having previously studied the company.
- Funds (ETFs) associated with confident risk and average returns. If you don’t want to spend time figuring out the history and state of affairs of several companies, this option is for you. The funds include several companies from the same industry, that is, by buying a share in the fund, you buy a share in several companies at the same time.
- Bonds bring the least money, but are the safest. They protect the portfolio if the market is at the stage of stagnation.
- Futures are the most risky, but also one of the most profitable options. This is an agreement on the mandatory purchase or sale in the future of an asset at a price agreed in advance. In essence, this is trading: if you are sure that the exchange rate will rise, you enter into a contract to sell this currency at a specified price. If, contrary to expectations, it falls, you lose money.
It is impossible to say exactly which area will begin to grow in a few years, and which will face a significant decline. For example, during this crisis, the shares of airlines and travel companies fell, but the securities of medical and IT corporations rose.
If you had only airline stocks in your portfolio a few years ago, it has suffered a lot, even despite the dividends.
Choose the areas in which you are best versed. Let there be from one to three companies in each industry. Another important indicator is macroeconomic indicators in the world.
An alternative tool can be, for example, real estate funds. These are funds created to invest in construction projects. Most often, these are closed-end mutual funds. Among them:
- Rent created for real estate management. The objects of investment can be both commercial and residential real estate.
- Construction, focused on the construction of facilities.
Development, created for the development of land or finished objects;
- Land, focused on carrying out operations with the land.
By investing in a real estate fund, you are investing in a company that owns, manages, or finances income-generating real estate.
Also, distribute money between assets in different countries. It is difficult to imagine what changes in politics or the economy await us in the future.