Trading in financial markets can bring profit and losses in turns. There are plenty of reasons for losing money, starting with unpredictable behavior of assets and through an unwisely collected portfolio. This article is devoted to the latter reason, discussing basic approaches to diversifying your portfolio for decreasing risks and getting the maximum from the market.
We all know the saying: “Never put all the eggs in one basket”, and it perfectly describes the danger of undiversified portfolios. Putting all the eggs in one basket here means investing everything in one instrument and waiting for a profit. Practice shows that this strategy does not always work.
What is diversification?
In investment, diversification means distributing your investment capital among various financial instruments to decrease risks and increase profit. This approach helps to compensate for possible losses that emerge from a decline of one of your instruments by making a profit on your other instruments.
Until the 1950s, diversification principles in the stock market were limited by fundamental analysis (Graham and Dodd’s theory): people chose investment options by studying the business of issuers, almost neglecting risks.
In 1952, in the Journal of Finance there was published an article on collecting an investment portfolio by a young postgraduate Harry Markowitz. His ideas from the article and his PhD thesis became the base for the modern portfolio theory.
Markowitz described a fully mathematical approach to forming an investment portfolio that allows choosing assets based on the profit/risk ratio. In 1990, he won the Nobel prize for his research.
In this article, I will not describe Markowitz’s ideas or the statistical aspect of forming a portfolio because these are the topic for a different, much more detailed talk. Before starting such a talk, you will need to understand the basic principles of diversification to avoid putting all the eggs in one basket already at this stage.
Basic diversification principles for an investment portfolio
In the modern world, all the branches of the economy cannot be growing at once. Hence, investors need to distribute their capital in such a way that in the case of a slump of an asset or group of assets in one sector of the economy the portfolio still generated a profit.
The basic diversification principle presumes distributing your investment capital among the shares of companies from different branches of the economy, as well as among various financial instruments.
Main branches of economy:
- Heavy industry
- Healthcare, biotechnology, pharmacology
- IT and computers
- Finance and banks
- Oil production and processing
Main market instruments:
- Shares of companies
- Currencies and currency pairs
- Futures for goods and commodities
How to diversify your investment portfolio?
If an investor decided to form their portfolio without mathematical calculations, they must use as much fundamental data about the current market situation as they can collect.
I suggest that we should together try to assess current economic events and check the potential of various instruments if they were included in your portfolio.
Analyzing fundamental economic factors
Judging by the trends of 2021, when the pandemic of COVID-19 is still raging and even getting more violent in certain countries, the shares of IT companies are falling because borders are closing and passenger flow is subsiding.
Theoretically, these shares will start growing when the pandemic is over but we have no idea when this happens. The stocks of transport companies can become a long-term investment, and a rather cheap one. Risks, however, are increased here: no one knows when they will be back in business.
Healthcare and pharma sector has grown a lot compared to its pre-pandemic state and still have room for growth.
With all the lockdowns and closed borders, people are stuck at home, trying to find IT. Companies producing such content and offering it online look attractive. So do companies working in IT — for many people, the Internet is becoming virtually the only way to get distracted from things around. Hence, theoretically, the shares of such companies might continue growing.
Oil-producing and processing companies are losing money because transportation is poorly active. On the other hand, cargo transportation is still enjoying fair demand, and transporting companies keep consuming fuel.
Construction companies demonstrate no growth but look promising: buying cheap construction sites at the current stage, you can expect significant growth in the future.
Heavy industry is doing worse then IT; however, when the pandemic is over, people will need to repair machines and get new materials, which might raise the profits of companies and take their quotations up.
The banking sector has lost a lot of corporate clients as many small and medium business stopped working, but in the nearest future things can change.
Collecting a portfolio for long-term investing, you can distribute your capital among companies from these sectors: uncertainty and risks of some investments will be partly insured by positive trends in other ones.
Analyzing the potential of financial instruments
Above I have speculated on stocks. Another basic approach to portfolio diversification presumes distributing your capital among various financial instruments as well.
Bonds are not the most profitable investment option but they are the most stable one. You should not exclude them from your portfolio.
With all the political debates and events going on, why not invest in the currencies of developing countries? When lockdowns are over, tourist destinations will become promising.
People, craving for a vacation abroad, will be happy to bring their money there, enforcing the currencies of tourist countries.
Gold has always been in demand and keep growing even after pullbacks. Also, you are not obliged to stop on gold solely: consider silver, widely used in industry, or platinum, also demanded in jewelry and manufacturing.
ETFs unite stocks of various companies and allow investing in a whole set of assets. Meanwhile, there are pretty many ETFs which gives investors a choice. Investing in them, keep in mind that taxation of your dividends will be increased.
Futures are another diversification instrument. There are futures for stocks, currencies, indices, and commodities, say, agricultural products (sugar, wheat, corn).
Investing in agricultural derivatives, mind the weather in exporting countries because it directly influences crop and, hence, the price for the final product.
To sum up, I would like to say that diversifying your portfolio is not a task for one day. You need to keep an eye on the market and sometimes change some assets for others. As a rule, after some stocks grow, they correct, and wait until the correction ends is unwise. It will be more profitable to get rid of one asset and buy a promising undervalued instrument.
Also, keep in mind that I have told you about just the peak of the iceberg called “portfolio diversification”. Apart from deciding in which “baskets” to put your money, you need to decide at what rate, as well as calculate profitability and risks.