There is a portfolio theory that postulates the basic principles of portfolio diversification. If you follow the postulates, you can create a portfolio that will bring you maximum profit at minimum risk. Theoretically.
You have to invest in high-risk securities if you want to gain maximum profit. However, the price of high-risk securities can rocket or plummet. For this reason, you have to have a balanced portfolio. To high-risk securities, you have to add some low-risk securities such as government bonds, for example. The bonds will help you reduce the overall losses in case the price of your high-risk securities drops sharply.
Besides, you have to regularly rebalance your portfolio. Suppose that you have 70% in shares and 30% in bonds. Suppose now that the value of shares goes up over time and one day it turns out that you have 80% in shares and 20% in bonds. It is time to rebalance your portfolio: sell some shares and buy some more bonds.
Another theoretical postulate says that you should buy securities that do not correlate in any way. In other words, you have to have securities that show opposite tendencies in a certain situation in the stock market. For instance, one type of securities adds value when the price of oil goes up while another type of securities loses value. If you have both of these types of securities in your portfolio, you will be protected from volatility in the market because the gains will compensate for the losses.
Advantages and disadvantages of portfolio diversification
When comparing asset protection options and considering portfolio diversification, you have to realize that each option will have its pluses and minuses and portfolio diversification is not an exception. There is no ideal asset protection mechanism, unfortunately. Below we discuss the main advantages and disadvantages of portfolio diversification.
Advantages of portfolio diversification
Overall risk reduction. If you put all your money into a single company and it suddenly goes bankrupt, you suddenly will go bankrupt too. If you have shares of different companies and some of them lose value, it is likely that some other shares will gain value. In this way, your overall loss will be reduced or even leveled out.
An opportunity to invest part of your money in high-risk securities. You would not want to put all of your money in high-risk security for the fear of losing it. However, if you have some of your money in ‘secure securities’, you can take the risk and invest some of it into potentially profitable securities.
Protection against volatility. If you have a well-balanced portfolio, you are protected from sharp price falls. It seldom happens that all types of securities depreciate simultaneously.
Better long-term prospects. A diversified portfolio may not bring you high profits but long-term stability is a very important thing. Ask yourself: is it better to be sure of having something or to be unsure of having a lot?
Disadvantages of portfolio diversification
Diversification does not protect you against systemic risks. If the entire financial system crashes, a diversified portfolio won’t save you.
The more different securities you have in your portfolio, the harder it is to manage them. It just takes too much time.
The more assets of different types you buy, the more commissions you pay. Portfolio diversification can become an expensive enterprise as it is.
While portfolio diversification protects you from losses in the long run, it may disallow you to earn money in the short run. Suppose that you have purchased shares of 5 companies putting 20 thousand dollars (euros, pounds, etc.) into each company. Suppose now that one company’s shares have grown by 50% and the prices of other shares have not changed. You have earned 10 thousand while you could have earned 50 thousand if you had put all the money in the more successful company.
Portfolio diversification strategies
Below we discuss the main strategies of portfolio diversification. Each strategy can help you reduce risks to a certain degree.
Diversify by the asset type
You have to buy different types of securities and other assets to keep your portfolio diversified. These include shares, bonds, and ETFs in the first place. Even an inexperienced investor can figure out how to buy different kinds of securities.
A more experienced investor can also consider buying futures but this is a riskier and a less predictable instrument.
Company shares normally serve as the largest profit-generating part of your portfolio. Exchange-traded funds (ETFs) are profit-making low-risk securities. An ETC will normally hold securities of several companies at a time. Thus, using this instrument, you buy shares of several companies in one go. Bonds serve as the protective part of your portfolio. They bring less profit than shares and ETFs do but they are the most secure type of securities.
We have to note, however, that bonds can be issued by national governments, by municipal governments, and by corporations. Government bonds are the most secure type of bonds because bankruptcy of a national state is less likely to occur than bankruptcy of a municipality or a corporation.
What portion of shares should your portfolio contain in relation to other types of securities? The answer to this question will depend on the level of your preparedness to risk. The larger the portion of private company shares is, the riskier is your portfolio. If you would like to minimize the risk, you should have 50% of bonds in your portfolio.
Diversify by the industry
It is also important to buy shares of companies working in different industries. The present crisis shows this very well. While some stocks are going down, others are going up. If you have both types of stocks in your portfolio, it means that it is well-balanced.
Due to the recent Covid-19 pandemic, oil and gas companies and air carriers suffered a lot, for instance. On the contrary, the agricultural sector and retail companies made greater profits than before. Imagine that you had shares of only oil and gas companies and air carriers in your portfolio at that time. You would have made great losses then.
The following main sectors of the world economy can be identified: oil and gas, telecommunications, petrochemicals, electric power, IT sector, metallurgy, pharmaceuticals, finance and banking, mining, retail, construction sector, transportation. The last sector can be subdivided into car manufacturers, aviation companies, and sea transportation companies.
You do not necessarily have to invest in all these industries. Choose the ones that you understand better, the ones whose business processes are clear for you. In addition, you can look into the macroeconomic indicators of a certain industry within a national state or in the world. When you have identified the types of stocks that you are going to invest in, you should start looking at different industries.
Diversify by the currency
It may be helpful to have some stocks in your portfolio that you can sell for dollars, some stocks that you can sell for euros, and so on. National currencies fluctuate and you can take advantage of a beneficial exchange rate when you have a chance.
Diversify by the country
Diversifying your portfolio geographically is not less important than diversifying it by other parameters. True, global diversification can make your portfolio hard to manage but geographical asset diversification is one of the most efficient asset protection mechanisms. Offshore Pro Group specializes in geographical diversification of assets.
