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For the conscientious investor, diversifying investments is not just common advice, but a fundamental strategy for mitigating risks, balancing volatility and maximising returns over time.
The wisdom behind the saying "never put all your eggs in one basket" resonates deeply with the philosophy of diversification, which seeks to spread invested capital across a variety of assets.
A diversified investment portfolio is not limited to a single type of asset, but rather a carefully selected mix of different asset classes. These assets can be domestic and international, direct treasury bonds, cryptocurrencies, property, etc.
By diversifying investments across a wide range of assets, the investor reduces exposure to risks specific to each asset class and increases the chances of obtaining consistent returns over time.
Investment diversification is not just about spreading capital between different assets, but also about ensuring that these assets are not correlated with each other.
In other words, the performance of one asset should not be strongly influenced by the performance of other assets in the portfolio. This lack of correlation helps to reduce the volatility of the portfolio as a whole and protects against significant losses in times of instability in the financial markets.
As well as protecting against specific market risks, investment diversification also offers opportunities for growth in different economic scenarios. While some assets may outperform in certain conditions, others may excel at different times.
By adopting an investment diversification approach, investors can build a robust and adaptable portfolio, capable of withstanding challenges and taking advantage of opportunities that arise over time.
In a world of uncertainty and volatility, diversification remains an essential strategy for those seeking to protect and grow their assets in a consistent and sustainable way.
Understanding Diversification in Practice
Let's say your investment portfolio consists only of shares in the tourism sector. On a certain day, you read some bad news that potentially affects this sector and you notice that the value of the shares of the companies operating in this field has fallen by 20% - so this means that the value of your portfolio has also fallen by 20%, since you are only exposed to this one sector.
However, in another hypothetical scenario, you have your investments equally diversified between electricity and tourism stocks. You read the same bad news that negatively affects the tourism sector, causing a 20% drop in the value of the shares of companies operating in this field - but in this specific case, you are no longer 100% exposed to the tourism sector, since you have half of your investment portfolio in electricity shares. So the devaluation of your portfolio is no longer 20%, but "only" 10%, since the electricity sector has not been affected by the bad news specific to the tourism sector.
The great secret of this type of strategy is to invest in sectors and/or assets that have a low correlation with each other, in order to mitigate the risks of your investment. Different assets such as shares and Treasury Direct, for example, do not react in the same way to adverse events.
Combining these different assets will make your portfolio less sensitive to market fluctuations, since they move in opposite directions. In other words, the lower the correlation between assets, the less your investment portfolio will fluctuate.
Different Types of Risk
We can divide the risks into two categories: the systemic risk and non-systemic risk. But what are these risks anyway? Valor e Capital explains:
O systemic risk is a risk that affects the market as a whole, i.e. a type of risk associated with any company. Examples of systemic risks include inflation, interest rates, exchange rates and political instability, among others. Unfortunately, this type of risk is inherent in all investors and cannot be reduced by diversifying your investments.
However, it's important to remember that not all assets are affected equally - a rise in interest rates affects both fixed-income investments and shares, but in different proportions.
O non-systemic risk is what can be avoided by diversifying your investment, since this type of risk is specific to a company or sector. Examples of non-systemic risks include changes in the regulation of a particular sector, changes in the management of a particular company, the entry of new competitors into the market, among others.
Advantages and Disadvantages of Diversification
While diversifying your investment portfolio is a great strategy for protecting yourself from volatility and risk, it also has its drawbacks, especially if you start with little money, as you run the risk of spreading your profits thinly.
There are a number of factors you have to take into account before diversifying your investments - such as brokerage fees and the difficulty of managing several assets in different brokersfor example. We've listed some pros and cons below:
Pros:
- Reduces the risk and volatility of your portfolio;
- Higher returns in the long term;
- Exposure to different assets.
Cons:
- Different brokerage rates;
- It is more difficult to manage the assets, as they are held by different brokers;
- Limited short-term returns.
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