Diversification In Investing

The key to intelligent investing is diversification of the investor's portfolio. This technique reduces exposure to risks by allocating investments across various groups of assets.

Following the principle of diversification, an investor can purchase stocks of companies operating in different sectors of the economy. It allows him to build a well-balanced portfolio, where an investment loss due to a decline in some assets could be offset by lucrative investments in the other sector. Smart diversification doesn't mean acquiring as many assets as possible. It's important to understand the peculiarities of each financial instrument and evaluate its prospects. Diversification is essential for any portfolio. It reflects the famous saying: "Don't put all your eggs in one basket."

What is the purpose of diversification?

As we’ve already mentioned, the main goal of diversification is to mitigate potential losses. At the same time, less risk means less profit.

But investing implies keeping a cool head. So it makes sense to earn less while keeping your investment income steady. The financial world has seen many cocky investors who ended up losing their money in pursuit of huge profits. In addition, thoughtless investment only inflates "debt bubbles" that will burst sooner or later, plunging certain sectors of the economy into a crisis.

Diversification Strategies

Investors use several popular diversification strategies. These include:

Diversification by assets. The main goal of this strategy is to ensure portfolio stability in unfavorable periods. To do this, we recommend  investing in different types of assets. Investors fill their portfolios with a collection of assets such as stocks, bonds, exchange-traded funds, deposits and indices. The former offer the highest return on the investment, allowing investors to profit from both trading and dividends. Stock market growth is usually aligned with a growing economy.

ETFs and indices, which include not one, but several companies, offer lower returns with moderate risk. The most protected part of the portfolio when using this strategy are deposits and bonds. As for the share of such assets in your portfolio, it depends on your desired level of risk. A larger share of bonds in your portfolio reduces risk: your risk exposure will be minimal with 50% of bonds in your investment portfolio. 

Diversification by economic sectors. Allocating assets across multiple economic sectors ensures stability when a particular sector of the economy faces a decline. It makes sense to choose the most stable industries, such as oil and gas, IT sector, banking and finance, etc.

Diversification by currency. By allocating investments in various foreign exchange assets, you can be sure that your portfolio withstands sharp fluctuations in the foreign exchange market. Smart investors prefer to invest part of their capital in safe-haven currencies in order to protect their funds.

Diversification by country. Investing in the assets of one country can make your portfolio vulnerable to political and economic risks, as well as country risks i.e., risks associated with investing in a particular country. Such investments become especially dangerous in the case of long-term investments. To pick the best countries in terms of investment, one should check the so-called investment rating of countries, consider how reliable the country's financial institutions are, and other factors.

The choice of diversification method largely depends on the investor’s capital. The larger it is, the more diverse portfolio he can build. Also, a lot depends on the goals the investor pursues.

When it comes to protecting savings or hedging against inflation, the portfolio should be mainly composed of bonds. However, you should also allocate at least 10% of your portfolio to stocks.

To get a higher potential return, consider adding more stocks to your portfolio and allocate about 10-15% to bonds. They will act as a cushion against the unpredictable ups and downs of the stock market.

Hedging as a way to protect your portfolio 

Apart from diversification, you can also use hedging to protect your investment portfolio. Hedging is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. For example, a EUR/USD trade can be hedged with an opposite trade on USD/CHF since these pairs have a near-perfect negative correlation. This means that 100% of the time, when the EUR/USD rallies, the USD/CHF is sold off. 

Hedging is used to:

· reduce price risks;

· mitigate operational risks that depend on a business cycle;

· get rid of the uncertainty factor and increase predictability and transparency;

· increase stability;

As with diversification, there are different types of hedging.

To protect your portfolio, you can use a combination of hedging strategies or create your own hedging method. Usually, the hedging strategy is implemented taking into account several criteria, which include:

· type of hedging instruments;

· the amount of hedged risk;

· asset type;

· terms of the hedging contract, etc.

What is the difference between diversification and hedging?

While both instruments are aimed at protecting your investment portfolio, they differ significantly.

While diversification implies spreading your investments among a variety of asset classes to balance your portfolio, with hedging, you use specific assets with negative correlations to offset risks.

Diversification does not exclude the growth of risky assets along with safe-haven ones, which cannot be the case with hedging. Profits on the hedged securities will be accompanied by losses on the hedging ones.

· Diversification won’t save you in a crisis, but hedging can back you up when investors start to panic and dump risky assets.

· While diversification is used to reduce the risk of your entire portfolio, with hedging, you can protect both the entire portfolio and specific assets.

· While diversification works better for long-term investments, hedging can be used to protect your portfolio over a short period of time.

To reduce risks, it is reasonable to combine both of these risk management strategies. You can create a well-balanced portfolio by using diversification and allocating your assets across various asset classes. At the same time, hedging will help you reduce the risk of adverse price movements in a particular asset.