What is diversification and why do investors need it

2024 Author: Malcolm Clapton | [email protected]. Last modified: 2023-12-17 03:44

Even if you believe in Yandex's success, you shouldn't buy shares of just one company.

What is diversification

This is investing in various financial instruments, sectors of the economy, countries and currencies in order to reduce risks. It is important that parts of the portfolio react differently to the same events. So the increase in the value of some assets will help not to notice the fall in the price of others.

Let's say an investor bought two ETFs at the end of April 2021: one for US tech companies and one for gold. A person believes in the growth of stocks, but decided to play it safe: as a rule, the price of purchased assets changes in opposite directions - if stocks rise, then gold falls, and vice versa.

Over two weeks, technology companies' shares lost Information on the profitability of FXIT, 2021-29-04 - 2021-14-05 / FinEx 7% of its price, and gold increased Interactive chart of the value of the VTB - Gold Fund unit, 2021-29-04 - 2021-14-05 / VTB Capital by 3%. Investments were still reduced by 4%, but thanks to diversification, some of the losses were recaptured.

Diversification does not guarantee that an investor will avoid losses. But this is the most important component that reduces G. P. Brinson, L. R. Hood, G. L. Beebower. Determinants of Portfolio Performance / Financial Analysts Journal investment risk and allows you to achieve long-term goals.

How diversification helps you avoid losing money

The degree of diversification depends on the goals and characteristics of each investor. But the approach itself has several universal advantages.

Eliminates the risk of investing in one country, sector or company

If an investor distributed money among assets from different countries, then he insured himself in case of economic or political problems. For example, a 10% drop in the China Shanghai Composite Stock Market Index / TradingEconomics of the Chinese stock market in a month would be unpleasant if the portfolio contains stocks of companies only from that country. But when such firms account for half of the investments, and the second is invested in the index of American companies, then the person will eventually even earn a little S&P 500 Index / TradingEconomics.

Reduces asset volatility

An investor can build a portfolio so as not to take too much risk due to price fluctuations, but earn decent money. A textbook example is the effective Markowitz frontier, which shows the risk-reward ratio for several combinations of stocks and bonds.

Helps to build a portfolio

A diversified portfolio is likely to be less profitable compared to one or two investments in something fast growing. But the risk of losing money is also lower.

Allows you to quickly recover from the crisis

If you correctly distribute funds between different assets, then in a crisis the portfolio will lose less and recover faster.

Let's say two people invested $ 1,000 in January 2020. Investors hardly foresaw the crisis due to the coronavirus. The first bought only a fund of American stocks, and the second insured himself: he bought the same fund for $ 600, and Treasury bonds for another $ 400.

The first investor eventually made a dollar more, but only at the very end of 2020. And I was much more worried: the diversified portfolio sank by a maximum of 5, 67%, and from stocks - by 19, 43%.

It is important to understand that diversification will help protect oneself in times of crisis, but will not insure against a tremendous fall, as, for example, in 2007-2009, when almost all assets were lost in value. To get out of a serious crisis in the black, you need hedging. This is a complex method: professionals select instruments with a correlation of -1, that is, those that move in the opposite direction from the market.

How an investor can diversify a portfolio

The investor has many options for hedging, the specific set depends on the investment strategy. But there are several simple and accessible methods for everyone.

By asset class

The classic approach to diversification is to distribute investments among four main asset classes. Everyone behaves a little differently, the level of risk is also different:

1. Stock. The cost of a share in a company directly depends on the success of the company, its position in the market and the global state of the economy. It is difficult to predict future achievements or failures, so stocks are volatile: they can grow well, or they can collapse by tens of percent.
2. Bonds. Companies and states decide to take debt when they feel they can repay it. Therefore, the profit is easy to calculate, and the price does not fluctuate much. Investors are paying for this with low returns, which are only slightly higher than inflation.
3. Cash. They do not generate income by themselves, because of inflation they even lose value. But in the event of a crisis, cash is valuable, since it can be used to immediately buy other cheaper financial instruments.
4. Alternative assets. This category includes everything that did not fit into the previous ones, from real estate and precious metals to agricultural land and collectible whiskey.

Investments between these classes will already provide good diversification. For example, a private investor can easily buy four funds and not worry about the classes: SBGB (RF government bonds), FXMM (short US Treasury bonds), FXUS (US stocks), and TGLD (gold backed fund).

It also makes sense to choose funds because they are an additional bet on many securities. There is no ideal number of them, but there is convincing data from M. Statman. How Many Stocks Make a Diversified Portfolio? / The Journal of Financial and Quantitative Analysis that it is better to distribute investments between at least 18-25 assets.

Number of shares in the portfolio	Portfolio risk
1	49, 2%
2	37, 4%
6	29, 6%
12	23, 2%
18	21, 9%
20	21, 7%
25	21, 2%
50	19, 9%
200	19, 4%

But an investor can distribute investments even further: choose between companies of different sizes, invest in shares of promising companies or, conversely, undervalued ones, buy ten-year or three-month bonds.

By sectors of the economy

The stock market is usually divided into 11 sectors, each of which is divided into sectors. All sectors have their own characteristics: for example, IT is mainly composed of fast-growing companies, and industrial - of those that pay generous dividends. The utilities sector is considered protective because it is not particularly prone to crises, but the selective demand sector is cyclical, as it grows well only after crises.

When some sectors rise, others fall, and still others do not change. An investor can create a balanced portfolio of securities, taking into account the characteristics of different industries.

For diversification, a person can invest in industry funds. For example, AKNX invests in the top 100 technology companies on the NASDAQ, TBIO in biotech stocks, and AMSC in semiconductor manufacturers. An investor can also choose companies separately: most Russian firms and major foreign corporations are available on the Moscow Exchange, and about 1,700 foreign companies on the St. Petersburg Stock Exchange.

By country

Each has its own economic and political characteristics: in the United States and China, technology companies are strong, and in the European Union, it is important to take into account climate regulation. Investing in firms from different countries will allow you to choose the strongest industries and protect yourself from risks within one state. For example, due to domestic political problems, China's IT sector has lost Down $ 831 Billion, China Tech Firm Selloff May Be Far From Over / Bloomberg has lost about $ 820 billion since February, and US tech companies have added XLK Market Cap / Yahoo Finance one and a half trillion.

In addition, countries are divided into developed and developing countries. In the former, which include, for example, the United States and Great Britain, it is more profitable to invest in the middle of the business cycle or shortly before the crisis. The latter, for example China or India, perform better during global economic growth.

For country diversification, it is easiest for a private investor to choose an ETF: FXDE invests in large German companies, FXCN invests in Chinese companies, and SBMX invests in Russian ones.

By currencies

As a rule, investments in companies from different countries automatically guarantee diversification by currencies - after all, one corporation earns in dollars, another in rubles, and the third in yuan.

But if the investor does not see attractive firms for investments or is expecting an imminent crisis, then it is better for a person to distribute cash in different currencies. Suppose an investor lives in Russia, but considers the Chinese market to be promising. But so far a person is not ready to invest there: the Chinese Communist Party is raging with regulation, and the situation is similar to the pre-crisis one. For an investor, it would be reasonable to leave some of the money in rubles, transfer the other into yuan for purchasing assets at the right time, and a little more - in dollars and euros just for safety net.

How to combine diversification and investment strategy

If a person does not have an investment strategy, then it makes little sense for him to engage in diversification. Without a strategy, it is difficult to assess the optimal balance of risk and reward.

If all this is clear, then you can start combining assets. There are many approaches, one of the simplest is “modern portfolio theory”. Its authors suggest E. J. Elton, M. J. Gruber, S. J. Brown, W. N. Goetzmann. Modern Portfolio Theory and Investment Analysis, 8th edition for investors to start from just the time and the ratio of risk and return.

The general rule of the strategy: the shorter the investment horizon, the more conservative assets should be kept in the portfolio. The longer the period, the more risky.

Based on this, the authors of "modern portfolio theory" offer several templates that an investor can take note of.

Conservative	Share	Average yield
US stocks	14%	5, 96%
Shares of other countries	6%
Bonds	50%
Short-term bonds	30%
Balanced	Share	Average yield
US stocks	35%	7, 98%
Shares of other countries	15%
Bonds	40%
Short-term bonds	10%
Growing	Share	Average yield
US stocks	49%	9%
Shares of other countries	21%
Bonds	25%
Short-term bonds	5%
Aggressive	Share	Average yield
US stocks	60%	9, 7%
Shares of other countries	25%
Bonds	15%
Short-term bonds	–

There are a few things to keep in mind:

• The portfolio needs to be rebalanced. Market instruments are constantly changing in price, so you need to monitor the shares of assets in the portfolio. If in six months the shares soared by 50%, then you need to sell part and buy other assets in order to restore the original shares. Or revise the investment strategy.
• Any model is just an example. It is not necessary to buy US stocks, and bonds can be replaced, for example, by shares in a real estate fund. The exact mix of assets again depends on the investor.

What is worth remembering

1. Diversification is a way to spread investments so as not to lose money due to the problems of one company or a crisis in one country. The key principle is "don't put all your eggs in one basket."
2. The investor can diversify the portfolio by class and number of assets, country and currency.
3. There are many approaches to diversification, one of the simple ones is to take into account the investment horizon, desired profitability and risk tolerance.