Diversification of investments: the road to a more secure future

"Investing is like gardening. You don't plant all the seeds in one place."

In today's fast-changing economic environment, with inflation eating into savings and geopolitical tensions creating uncertainty, strategic management of the investment portfolio is more important than ever. While "don't put all your eggs in one basket" is a mantra familiar to almost every investor, this time we take a closer look at the nuances of diversification that will be of interest to anyone looking to manage their investments wisely.

This article sheds light on the complexities of diversification, from combining different asset classes to diversification strategies within each class. We discuss different approaches, potential risks and provide practical examples to help you make more informed investment decisions.

What is diversification and why is it important?

Diversification means allocating investments to reduce risk and increase potential returns. This includes both combining different asset classes (equities, bonds, real estate, etc.) and diversifying within each asset class. Think of it as an insurance policy for your portfolio to help protect against unexpected events.

Consider, for example:

If you invest all your money in shares in a company and that company goes bankrupt, you lose your entire investment.
However, if you split your money between shares in different companies, bonds and real estate, your risk is diversified and the failure of one company will not affect your portfolio as badly.
In addition, you can diversify your risk within shares by investing in different sectors (technology, healthcare, energy), companies of different sizes and geographical areas.

In addition to spreading risk, diversification also helps reduce volatility. Volatility is a measure of the price volatility of an investment. The more volatile an investment is, the greater the risk that its value will fall sharply in the short term. A diversified portfolio, on the other hand, is less volatile because the prices of different asset classes and instruments do not usually move in the same direction.

Asset classes and correlation

When constructing an investment portfolio, it is important to take into account the correlation between different asset classes. Correlation shows how the prices of two assets are related to each other. A positive correlation means that asset prices move in the same direction, while a negative correlation means that they move in the opposite direction.

Main asset classes:

Shares: Ownership stake in the company. Shares offer potentially high returns, but are also riskier.
Bonds: Loans to governments or companies. Bonds are generally less risky than equities, but also offer lower returns.
Real estate: Land, buildings and other real estate. Real estate is a relatively stable investment, but its liquidity is low.
Raw materials: Nafta, gold, silver, etc. Commodity prices are volatile and depend on global supply and demand.

Example of correlation: Stock and bond prices are usually negatively correlated. This means that when stock markets fall, bond prices rise. Therefore, having both equities and bonds in a portfolio helps to reduce risk and volatility.

Diversification strategies

Now that we understand why diversification is important, let's take a closer look at the different strategies that can be used to diversify a portfolio.

1. Strategic vs. tactical deployment

Strategic breakdown is a long-term approach where the investor determines the weighting of each asset class in the portfolio according to their risk tolerance and investment objectives. This allocation remains relatively stable over time, regardless of market fluctuations.
Tactical breakdown is a short-term approach where the investor makes changes to the portfolio according to market conditions. It requires active market monitoring and analysis and is suitable for investors who have the time and knowledge to predict market trends.

3. Index funds and ETFs

Index funds and ETFs are excellent tools for portfolio diversification. These funds typically invest in hundreds or even thousands of different securities that track a specific market index, such as. S&P 500 or OMX Tallinn. This ensures broad diversification and reduces risk. In addition, index funds and ETFs usually have low management fees, which is an important factor in achieving long-term returns.

5. Geographical dispersion

Geographical diversification means investing in different countries and regions. This helps to reduce the risk associated with economic or political instability in one country or region. For example, if your portfolio consists only of Estonian equities, a downturn in the Estonian economy will negatively affect your portfolio. However, if you also have investments in other countries, your portfolio will be better protected.

2. Passive vs active investing

Passive investing means investing in index funds or ETFs that track a specific market index. This is a simple and cost-effective way of diversifying a portfolio, as a single fund usually invests in hundreds or even thousands of different securities.
Active investing means selecting and buying individual shares or bonds. It requires in-depth analysis and knowledge and is more time-consuming than passive investing. Active investing aims to outperform the average market return, but it is also riskier.

4. Factor-based investing

Factor-based investing is a strategy where an investor selects stocks based on specific factors, such as value, size or profitability. This strategy is based on academic research that has shown that stocks with certain factors have historically offered higher returns.

6. Alternative investments

In addition to traditional asset classes such as stocks and bonds, there are alternative investments such as venture capital, artworks, collectibles and cryptocurrencies. Alternative investments can offer higher returns, but are also riskier and less liquid.

Diversion traps

While diversification is an important part of an investment strategy, it is also important to be aware of the potential pitfalls involved.

Over-diversification

While diversification is generally beneficial, it is also possible to over-diversify. Having too many different investments can make portfolio management difficult and costly. It can also reduce portfolio returns, as the returns from your best investments diverge from the returns from your average and poor investments.

Costs and fees

When investing, it is also important to consider costs and fees. For example, if you invest in actively managed funds, you will have to pay management fees, which can reduce your returns. It is also important to take into account transaction fees that may arise when buying and selling securities.

Emotional decisions

Investment decisions should not be driven by emotion. Fear and greed can lead to wrong decisions that can negatively affect your portfolio. For example, if stock markets fall, you may be tempted to sell your investments. This, in turn, can lead to the realisation of losses and prevent you from benefiting from the market recovery.

Behavioural biases

People are prone to behavioural biases that can influence their investment decisions. For example, confirmation bias means that people look for information that confirms their existing beliefs and ignore information that contradicts them. This can lead to wrong investment decisions.

Practical examples and case studies

Warren Buffetti portfolio

Warren Buffett is one of the world's most successful investors. His investment strategy is based on investing in quality companies for the long term. Buffett's portfolio is relatively concentrated, which means that he has large holdings in a small number of companies. This strategy has brought him excellent returns over time.

Ray Dalio and risk parities

Ray Dalio is the founder of Bridgewater Associates, the world's largest hedge fund. Dalio is renowned for its risk parity strategy, which allocates the portfolio equally between different risk factors. This strategy helps reduce portfolio volatility and protect against unexpected events.

Dot-com gauze

The dot-com bubble was a speculative bubble in the late 1990s involving shares in internet companies. The bubble burst in 2000, leading to a sharp fall in stock markets. This example illustrates the importance of portfolio diversification and risk hedging.

The 2008 financial crisis

The financial crisis of 2008 was a global financial crisis that started in the US real estate market. The crisis quickly spread to other countries and sectors, leading to a fall in stock markets and a recession. This example illustrates the importance of geographical diversification and investing in different asset classes.

Summary and FAQ

Investment diversification is an important strategy to help investors reduce risk and increase potential returns. It involves diversifying investments across asset classes, geographical areas and sectors.

It is important to choose the right diversification strategy for you, taking into account your risk tolerance, investment objectives and time horizon. It is also important to be aware of the potential pitfalls of diversification, such as over-diversification and emotional decisions.

We hope this article has given you a better understanding of investment diversification and will help you make more informed investment decisions.

FAQ

How many different types of investments should I have in my portfolio?

The optimal number of investments depends on your risk tolerance, investment objectives and time horizon. In general, 15-20 different investments are sufficient to achieve sufficient diversification.

Should I only invest in index funds and ETFs?

Index funds and ETFs are great tools for diversifying your portfolio, but that doesn't mean you shouldn't invest in individual stocks or bonds. If you have the time and knowledge, you can also try active investing.

How can I hedge the risk of my portfolio?

In addition to diversification, there are other risk-mitigation strategies, such as investing in low-volatility assets like bonds or gold. You can also use options and futures to protect your portfolio against market downturns.

Remember that investing is a marathon, not a sprint. It is important to be patient and consistent and to make informed investment decisions. Hopefully this article will help you achieve your financial goals!