The importance of diversifying your investments and how to do it without losing your head
Do you know the saying “don’t put all your eggs in one basket”? Well, this applies to your money, too. It is what is known as diversifying your portfolio and it is the key to your investments.
What is a diversified portfolio?
A diversified investment portfolio is one that invests in different types of stocks, from different geographical areas and sectors, for instance.
As you can see, diversification goes far beyond buying two, three or four stocks. In fact, doing that would mean simply having an investment fund, and that would not mean that your investments would be well diversified. It all depends on the fund you choose.
The key to diversification is not only in the number, but also in the types of stocks, their geographical area, and the correlation between them. This article will help you understand how to use each one to diversify your portfolio and why it is so important to do this.
The number of stocks you have is also important, but only to a certain extent. Now you will understand better.
Why diversify your investments?
Making money is just as important as not losing it when investing your savings. Diversifying helps to reduce the risk of your portfolio.
Imagine that you have 5,000 euros saved and you invest it all in a single stock. You are gambling your future on a single card. If that stock loses 50% of its value, your capital will be halved.
Add a second stock, in other words, diversify, and that same drop will reduce your losses to 25%. A drop of a quarter and not a half.
Invest in a total of 20 stocks and even if a stock goes to zero, you will only lose 5% of your portfolio. That is the importance of diversifying your investments and its magic: it mitigates losses and gives your investments stability.
As you see, the number of products or shares is important , although this is not the only element that you should consider in order to diversify your savings well. In fact, the University of Chicago found that over 30 different stocks, the effect of diversifying further in terms of reducing risk is almost nothing.
|Number of Stocks in Portfolio||Expected Standard Deviation of Annual Portfolio Returns||Ratio of Portfolio Standard Deviation to Standard Deviation of a Single Stock|
This is why we said that the number of different stocks is important, but it is not enough in itself. The key to everything is in what is known as stock correlation.
What is correlation when investing?
Correlation is a statistical term that refers to how two assets behave in the same situation or in response to the same stimulus. When this behavior is similar, the correlation is said to be positive and when it is not, it is negative.
For example, there is a positive correlation between European stock markets, as they all tend to follow the same trend. There is also a positive correlation between the American and European stock markets, so that when the market falls in the United States, it is usual that the next day there are falls in Europe.
Conversely, the correlation between fixed income (bonds) and variable income (stocks) is negative: when the stock market rises, bonds tend to fall or hold and vice versa.
Including assets that are uncorrelated or have a low level of correlation helps to reduce the volatility of your investment portfolio. In other words, the ups and downs are less pronounced. This helps to make your investment movements more stable, especially in times of uncertainty and downturns.
How to diversify your investments
There are several ways to diversify your portfolio to give it more variety and reduce risk. The most important are the following:
Diversification by asset type
This is one of the most important because it is key to matching your investment risk to your profile as an investor.
The first distinction when diversifying by asset type is to combine fixed and variable returns. Generally speaking, the first is more volatile and has more return potential, while the second is safer and more stable, but offers lower returns.
From this point, you can include other types of assets such as gold and even ones that are totally unrelated to the financial markets such as real estate, investment in loans, which involves investing jointly with other investors through specialized platforms, or investing in start-ups.
Diversification by geographical area
This means investing in different countries and geographical areas. In this way, bad news about one country’s growth will not affect your entire portfolio. When doing this, remember that some economies correlate more closely than others, such as the US and Europe; others are somewhat less well correlated, such as emerging countries.
Diversification by sectors
Not all sectors perform equally in all economic cycles. There are activities and businesses that do better in times of crisis, others that grow strongly in times of expansion, and also those that are more affected by inflation, to give three examples.
Diversification by currency
This is a further step in your diversification strategy. Investing in currencies other than your own serves to protect against a possible loss in the value of the euro, although it is also an added risk.
Finally, more experienced investors also tend to diversify by investment style. In other words, they include companies or investment funds, although their preferred style is usually what dominates.
The most common mistake when diversifying investments is to concentrate all savings in a single country. In the case of Spain, this means having your money in a national bank (logical), with deposits in Spain, shares only in the Spanish stock market and, in the best case scenario, a fund or pension plan also focused on Spain.
The result is that any negative news affecting the country will have a brutal impact on your portfolio.
Products to diversify your investments
An additional way to have a well-diversified portfolio is to invest in different products. At this point you should be clear that not all products carry the same risk and do not have the same degree of diversification.
For example, when you buy a share, you are buying a company that operates in one market and one country (or several). When you buy a share in an investment fund, you are buying a small percentage of all the companies in which the fund invests. These companies may be in one or more sectors and even in different countries. That is why it is said that a fund is a diversified product, although having a fund does not mean that you will have a well-diversified portfolio. The key is what the fund is investing in.
With this in mind, there are a number of products that already include a certain amount of diversification:
- Mutual funds
- ETFs or exchange traded funds.
- Pension Plans
- Savings insurance such as PIAS and Unit Linked.
These four products invest in different types of assets in different regions and offer greater diversification than buying a single stock. This makes them more suitable for the individual investor because they can have better diversification at a more limited price.
In conclusion, diversification is one way to reduce the risk of your portfolio, but not the only way. There is another very powerful tool that you can use as a private investor: time. In this article we tell you about the importance of the term of your investments.