Portfolio diversification: what is it? - How to make money

If you are a novice investor, you have probably heard about What is portfolio diversification? It helps to reduce losses during the fall in the cost of some resources and benefit from others. Let's talk about how to use this tool.

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When it comes to building the best investment portfolio, you often hear that diversification is key. But what does that mean – and why bother with it? After all, you already have a huge number of stocks that are skyrocketing at the moment: Amazon, Apple and eBay, for example. What can go wrong?

If you rely on a portfolio full of big tech stocks and are confident you'll live off the income generated by your retirement investments, you might be in for a surprise during the next market downturn. When the market is overvalued, it's easy for us to pick the “right” stocks, but when there's a correction, some investors lament that their portfolio isn't diversified enough.

Portfolio diversification: what is it in simple terms?

Have you ever heard the saying, "Don't put all your eggs in one basket"? The same principle encourages investors to diversify their money. In this case, you distribute them among different investment options, thus reducing the risk of losing all your money.

For example, when you diversify, you put some of your money into riskier trades and some into safer securities. The main idea is not to depend on one type of investment. If you lose money because of some investments, others are your lifeline and make up for the losses, providing you with a profit.

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Diversification is important because its absence increases risk and its implementation helps balance market downturns. Keep in mind that it is not enough to just distribute money between different companies. Collect portfolios from different areas, countries, types of investments.

Main types of diversification:

  1. Currency – is intended to use money in different currencies. For example, when you keep money not only in reais, but also in euros, dollars.
  2. Instrumental – intended to divide capital between different asset classes: stocks, futures, bonds, etc.
  3. Institutional – you distribute money between different companies. For example, you have deposits at different banks.
  4. Transit – you take profit from assets in different ways.
  5. Specific – in this case, the capital is distributed among different areas of activity: they invest in stocks, real estate, businesses, etc.

Diversification Strategies

Portfolio diversification: what is it?

age diversification

The distribution of investments is important at any age, but in some years you can afford riskier options, while in others you can choose the safest. So the younger a person is, the riskier a portfolio he can afford: the older you are, the harder it will be for you to recover from financial shocks. The rule is simple: subtract your age from 100. This is the percentage of money you can invest in riskier ventures.

For example, when you are 20 years old, you can hold 80% of high-risk stocks and 20% of “safe” investments like bonds, while a 40-year-old investor invests 60% of the budget in equities and 40% in “safe investments”.

Breakdown by assets

It is the diversification of the portfolio by assets that makes it possible to balance the financial situation during an economic crisis. Distribution options include:

  1. Stocks that generally generate more revenue, either through price appreciation or dividends. They grow after crises, during periods of economic growth. If the market goes down, you can buy more shares, having previously studied the company.
  2. Funds (ETFs) associated with reliable risk and average returns. If you don't want to waste time finding out the history and status of various companies, this option is for you. Funds include several companies in the same industry, that is, when you buy a share of the fund, you buy a share of several companies at the same time.
  3. Bonds bring in the least money but are the safest. They protect the portfolio if the market is in a stagnation stage.
  4. Futures are the riskiest options, but also one of the most profitable. It is an agreement to buy or sell an asset in the future at a previously agreed price. In essence, this is trading: if you are sure that the exchange rate will increase, you enter into a contract to sell that currency at a specified price. If, contrary to expectations, it goes down, you lose money.
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Sector distribution

It is impossible to say exactly which area will start to grow in a few years and which will face significant decline. For example, during this crisis, stocks of airlines and travel companies fell, but bonds of medical and IT corporations rose.

If you only had airline stocks in your portfolio a few years ago, it suffered a lot, even with the dividends.

Choose the areas in which you are most versed. Be one to three companies in each sector. Another important indicator is the macroeconomic indicators in the world.

additional tools

An alternative tool could be, for example, real estate funds. These are funds created to invest in construction projects. Most of the time, they are closed-end mutual funds. Between them:

  1. Rental created for real estate management. Investment objects can be commercial and residential real estate.
  2. Construction, focused on building facilities.
    Development, created for the development of land or finished objects;
  3. Land, focused on carrying out operations with the land.

When investing in a real estate fund, you are investing in a company that owns, manages or finances income-generating real estate.

Also, distribute money between assets in different countries. It is difficult to imagine what changes in politics or the economy await us in the future.

That is all! Develop financial thinking with Ilya Sitnov. Subscribe to our newsletter here and on Yandex.Zen so you don't miss out on useful materials.

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