Divide and conquer! The power of diversification

The diversification of portfolios is one of the basic fundamentals in the world of investments. Although it is a very easy concept to understand, putting it into practice could be a challenge. Diversification is one of the first concepts implemented in risk management, but at the same time where most investors make mistakes.

Diversificación, smartasset.com

From the financial risk perspective, the main aspect that gives meaning to a diversified and balanced portfolio is the ability to maintain positive performance, even when some sectors of the market are in loss. However, over-diversification can present serious problems in portfolio performance, due to the complication of managing it, which can lead to bad decisions, lack of attention or knowledge, or management errors.

Diversification, its definition

In basic terms, diversification consists of combining multiple strategies, sectors, and investment instruments in a portfolio, so that risk is spread throughout the spectrum of available investments and is not focused on a particular sector.

Diversification becomes a arduous task for everyone involved in the world of investments, both for financial planners, large funds, or individual investors. This is because there are assets that offer much higher returns than others, which prompts excessive amounts of capital to be placed in these assets, overexposing capital to the failure of that particular asset.

As mentioned earlier, the main goal of diversification is the management of risk in the portfolio, however, there are other associated benefits worth mentioning:

• Exposure to different sectors, allowing the opportunity to identify new investment opportunities;

• Reduction in the general volatility of the portfolio, allowing for more stable results in the short and medium term;

• Decreased dependence on particular sectors;

• Possibility of understanding the operation of different sectors.

Disadvantages of diversification

The main disadvantage of diversification is the limitation of investing capital in assets that offer extraordinary return rates, along with the added complication of having to monitor different instruments or sectors. Under the premise of diversification, opportunities for high returns must be taken advantage of with a limited amount of capital, without losing sight of the accurate distribution of resources in different assets or instruments to maintain risk at acceptable levels.

For example, at the beginning of 2021, the cryptocurrency market was in an accelerated bull run, providing extraordinary returns that exceeded hundreds or thousands of percentage points in a few months. Many investors moved their entire capital to this market, which allowed them to accelerate the multiplication of their net worth, but at the cost of a dramatic exposure to a highly volatile and risky sector. Many analysts consider that the cryptocurrency market bubble is comparable to the technology company bubble at the end of the 20th century, during the dotcom bubble.

Following the diversification concepts mentioned earlier, the capital destined for this highly volatile type of market must be kept limited, to ensure some exposure, without exceeding acceptable risks.

Tips for Creating Strong and Balanced Portfolios

Diversification of portfolios is not a new concept, as its importance has been proven over the different financial crises suffered by the markets in recent decades. Major investors have emphasized the importance of diversification above all things. Currently, it is possible to know the different diversification strategies put into practice by different funds, big investors, and investment firms, which make their portfolios public and offer the opportunity for individual investors to learn from their strategies.

In summary, the following tips can be highlighted:

• Divide net worth into investments in different sectors;

• For stock market investments, give weight to ETFs over individual stocks;

• Do not overlook the real estate industry;

• Keep reserves in cash, including a portion for reinvesting in other sectors when opportunities arise;

• Know the sectors in which you operate;

• Place capital in indices and bonds;

• Continuously evaluate portfolio performance and adjust as needed;

• Keep the portfolio constantly growing;

• Do not overlook transaction costs and fees.

Diversification basket, freepressjournal.in

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