What is diversification?
Like everything in life, there is nothing that is free of risk, financial investments are no exception. Diversification is essential to be successful when it comes to investing. But why is it convenient to diversify our heritage? And how can we achieve a truly diversified portfolio?
1.- What is diversification?
Anyone who talks about financial investments also talks about risks. Before investing your money in financial assets, you should know the risks associated with each of these. Only then can you distribute and minimize them in a second step. When it comes to finance, diversification is aboutdistribute your money among different types of investments and types of assets, with the objective, on the one hand, of avoiding a total loss of invested capital and, on the other hand, of benefiting from the largest number of companies with exceptional returns.
2.- Correlation between risk and profitability in financial investments
When investing, it is very important to regularly check how much and what risks your investments entail and how to avoid the risk of losing money. In the past, there have been enough examples of both private investors and banks or insurance companies underestimating such risks.
At the turn of the century, many private investors lost a lot of money due to unrealistic growth and performance expectations from young tech companies whose high valuations were not justified. This is known as the .COM bubble.
You don't have to go that far back. During the global economic crisis of 2008 and 2009, some banks, such as Lehmann Brothers, even had to declare bankruptcy because they misjudged the risks of the US housing market.
These examples have the same common denominator, investors who only look at high returns forgetting a basic principle, thathigh returns mean higher risk at the same time.
The riskier an investment is, the higher the potential return, which investors demand in exchange for that increased risk. Who wants a safer investment, generally has to settle for a lower return, but at the same time safer. In the article where we explained what bonds are, we saw that, for example, Brazilian government bonds yield a higher yield than bonds.bondsfrom Spain, Japan or Colombia. Investors demand to be compensated for higher risk and for this reason the Brazilian State has to offer higher interest rate bonds. Why is it riskier to invest in Brazil? This is so, because the probability that Brazil does not pay all or part of its debts is estimated to be greater than that of Spain or Japan. If we now comment on the case of Argentina, where a few months ago the State announced a suspension of payments on its public debt, that is, a part of the investors did not recover the money from their State bonds. For this reason, Argentine bonds have a clearly higher profitability, because the risk that the Argentine State enters into suspension of payments again is much higher. The States that are considered less risky, pay less interest to their investors or bond holders for their public debt, than the States, which present a higher risk.
Now that we know how to identify where there is more or less risk, we must ask ourselves how we reduce the risk of our investment portfolio.The keyword to minimize risk is diversification.
The expression "don't put all your eggs in one basket” is surely known to all. Why does this say? Well, if the basket, where all the eggs are, falls over, presumably all the eggs will break at once. For this reason it is better to distribute the eggs in different baskets. The principle of risk sharing goes back to the two professorsHarry M. Markowitz and Merton H. Miller [The Founders of Modern Finance: Their Prize-Winning Concepts and 1990 Nobel Lectures],who investigated the positive effect of diversification on risk and return. Thanks to this they obtained a Nobel Prize.
3.- The two types of risk
To know how to minimize risk, we must first know that there are two basic types of risk in financial assets: The first isindividual riskand the second is theoverall market risk, that all financial assets entail.
The two types of risk are fairly well explained using a car owner as an example. The owner of a car has an individual risk on the car for example theft. If your car spends a lot of time parked on the street or does not have an anti-theft alarm or is easy for a thief to open, that is an individual risk for your car. Companies also have an individual risk, for example, when they have bad managers or due to low competitiveness or due to legal disputes that only concern that company.
Market risk or also called systemic risk is a general risk. If, for example, there is a hail storm in the area and the car is still parked outside a garage, not just one car will be affected, but all cars in that area. The same happens with companies, when an entire market loses value, such as the Spanish market, then all companies will be affected regardless of how good or bad the company is. Even if the company has a very good position in the market, there is a high probability that its shares will lose value in the market.
4.- Diversification as a risk minimizer
Now that we know the two types of risk, we have to consider how we can minimize them. We can minimize individual risk by copying the insurance model. If the car owner wants to insure his car against theft, for example, he takes out auto theft insurance and regularly pays an insurance premium, which covers the financial risk in the event that his car is partially or completely stolen. In return, the insurance company assumes the risk of the theft and pays you an amount in case of theft, perhaps even more than the sum of all the premiums you have paid up to the date of the theft. The insurance company can afford this as it insures thousands of cars against theft and thus spreads the risk among many owners. The insurance company knows that if the risk of theft in an area is 2%, then it will have to replace or repair approximately 2 out of 100 insured vehicles per year. On a large base of insureds, the insurance company calculates how high the premium has to be to compensate for possible subtractions. The risk of theft is distributed in this way among all the insured. The same applies when it comes to investing, it makes little sense to invest all the capital in a single company or in a single stock, with a high individual risk. makes more senseto distributethat moneybetween different companies. Like the insurance companythus individual risk can be reduced.
Market risk can be minimized in the same way as individual risk. In our example, if the risk of robbery in the area increases from 2% to 10%, the insurance company could quickly go out of business if it does not adjust the premium accordingly. To offset this risk, the insurance company may add other types of insurance, such as tire insurance or insurance against glass breakage or other damage. Additionally, the insurance company may decide to operate in different regions, such as in regions that are socially safer and in regions with poorer asphalt where tire and glass damage are more frequent. Thus the risk is distributed between different types of insurance and in turn regionally. Translated into the world of financial investments, it means that you must distribute the moneyin different baskets, that is, investin different countries,investin different sectors and in different classes of financial assets.
It is inevitable to deal with the issues of risk and risk minimization when investing. Insurers and banks employ legions of mathematicians and controllers, who do nothing all day long but calculate and estimate risks and think about how to avoid those risks.
In addition to individual and market risks, There are also other types of risk.such as theinterest rate risk,default riskor theforeign exchange risk.
5.- Types of diversification
Based on the example of cars and insurers, it is very easy to identify the different ways to diversify:
1) The first is thenumerical diversificationthat allows us to minimize individual risk. Instead of investing €10,000 in Banco Santander shares, it is much better to invest €1,000 in the 10 best companies in theIBEX 35. Thanks to ETFs, you can start investing with very small capital and with access not only to 10 companies or the 35 companies on the IBEX35, but to a much larger number.
2) The second is thegeographic diversification. existETFswhich in addition to allowing you a numerical diversification, also allows you a geographical diversification, distributing the capital between the different continents or between developed and developing countries.
3) Geographical diversification must also go hand in hand withcurrency diversification. It is good to invest in Spain, Germany and Italy, but if the Euro goes through a bearish phase, our investments will be negatively affected. This is why it is important to also diversify into various currencies so that you are not only exposed to a single currency.
4) And finally we have to talk about thediversification of financial assets. There are many assets within the financial markets beyond shares, such as bonds, derivative products or investment funds. However, it is convenient to diversify beyond the financial markets, including in our portfolio real estate investments and alternative investments, such as crowdlending, crowdfunding, P2P credits or cryptocurrencies.