“Don’t put all your eggs in one basket”. That saying perfectly sums up the meaning and the essence of diversification, especially when it comes to investments.
There are numerous strategies, making diversification more and more efficient, but there is always a main purpose of diversification: to reduce the risk of investment and to increase the average financial performance. Without diversifying your investments you may lose all the money if the situation will turn negative for that single investment asset you own.
How do we know that diversification works? The answer is plain and obvious, at least for economy experts. All assets are affected by economic events in a different way and there are hundreds of factors influencing stocks, bonds, Real Estate, currencies, and commodities. Every day macroeconomic factors and data are released and markets react immediately by plunging or skyrocketing prices.
Below we will explain in detail what types of risks could undermine the effectiveness of investment and how to diversify the entire portfolio in the best way.
Type of risks
Generally speaking, there are systematic and unsystematic risks, where events either affect a large number of investment vehicles in your portfolio, or only a few minor assets. For example, a strike of a certain company’s employees will impact the price of that Company’s shares specifically.
1. Economic Risks
If the economy goes down it often “drags” the price of shares of real estate companies, companies from the public service sphere, technological companies, etc.
2. Political Risks
That implies that a Government changes its political direction so these changes affect, let’s say, a certain industry (military, air and space equipment, etc.). Obviously, the shares of companies related to affected industries will drop, so it’s wise to diversify shares by industries. Means instead of investing in several companies of one industry, you better buy shares of companies from totally different (and non-related!) spheres.
3.Interest Rate Risk
If the interest rate changes it inevitably affects related assets. For example, if the interest rate for the fixed income assets like bonds decreases, the value of your investments (if bonds are the part of it) goes down as well.
There is also the federal funds rate or so-called overnight rate, which affects market (and therefore investment assets) massively.
4. Credit risks and the risk of default
If you own equities issued by the Company which failed to match its financial obligations, it may lead to the default and, as a result, all the papers (especially bonds) devaluate.
5. Unpredictable risks
Theses are the risks of a sudden and unforeseen nature which may affect assets most significantly. New sanctions or vetoes may decrease the price of oil on the world market, while you’ve invested in oil futures or you have bought shares of Oil Corporation, etc.
6. Risks of investing in Commodities, Currencies, and Real Estate
Investing in commodities and other high-risk assets can be highly profitable, especially with appropriate diversification strategy. The range of risks is huge and every type of commodity is under its own specific threat.
7. Risks of investing in Commodities
Commodities are a synonym of risk due to the prices’ high volatility. As commodities (like crude oil) are traded mainly in a form of Futures, there is a risk you’ve paid a higher price than the market shows on the date of the future’s “delivery” (the date when you have to sell the Futures). But again, the potential profit may outweigh risks and losses taken from other assets in your investment portfolio.
8. Risks of investing in Currencies
Investing in currencies almost always means Foreign Exchange trading where the profit is taken from buying one currency against another in hopes the price of the first currency will rise. The price fluctuations depend on a huge diversity of factors: macroeconomic data (unemployment rate, central bank rate, etc.), and swings could be too sharp. To not to lose all the money it is recommended to diversify the portfolio with “opposite assets” (for example gold).
9. Risks of investing in Real Estate
In times of global economic crisis, the market’s price of commercial and residential Real Estate goes down. People start saving money having no wish to spend it until economy is recovered. Investing in Real Estate could turn into financial hardship if you have put all your money into buying shares of Real Estate companies or the Real Estate object itself. In order to balance the portfolio, you may diversify it by adding gold or corporate bonds.
10. Risk Management and Diversification as its main element
Risk management’s foundation is diversification. In order to predict and prevent possible complications caused by assets depreciation or unforeseen events lead to investments loss, it is wise to follow the rules of the risk management concept. Risk management concept is simple: minimize the risk by distributing the certain types of assets according to the strategy. For example, the base of the investment portfolio should consist of 50% assets with low-to-average risk level which bring moderate yet steady profit.
Another 20% put into high-risk assets which may bring an 80% profit, but could also be lost due to unforeseen and unpredictable market conditions. These are assets like currencies, shares of startups, highly volatile futures and stocks.
For investing the rest of your portfolio (30%) opt for low-income and fixed-income and low-risk assets like CDs, T-bills, etc. Don’t forget to monitor the market regularly for new investing opportunities.
How to diversify like a PRO!
Diversify your portfolio by assets classes: cash equivalents, equities (stocks) and fixed income assets like bonds.
- Add more fixed income assets, including such “uncommon” assets like indexes funds.
- Instead of just taking the profit and withdrawing it from the “circle”, you better reinvest it by adding some average-risk assets (50%), high-risk assets (20%) and low-risk assets (30%).
- In order to hedge risks of a high-risk portfolio use opposite assets, for example: if you are buying currency against the dollar in hopes that the price will rise, you also should sell (put a bet on price’s depreciation) this currency’s Futures. In a case the currency will go down you will still save a considerable part of your investment intact due to the Futures in the portfolio.
- When it comes to investing in stocks – buy the sphere you know at least something about. You must be able to make analysis and predictions on your own, so if you are a pro in medicine or high-tech industry – buy shares of companies related to these spheres.
- Avoid diversifying by buying long-term commodities assets. Unlike stocks, the strategy “buy and hold” cannot be applied to commodities. There are no steady up- or downtrends for commodities but rather constant prices fluctuations. Trade commodities, don’t own them.
- Don’t diversify commodities-based portfolio (like crude oil) by gold, as there is a direct correlation between oil and gold prices (if oil price rise, gold always follows).