Diversification is in simple words, I’ll tell you in 2 minutes

Updated July 24, 2022 172 Author: Dmitry Petrov
Hello, dear readers of the KtoNaNovenkogo.ru blog. Without knowing the basic economic terms, it is very difficult to understand the many processes taking place around us.

Therefore, today we will analyze the important concept of “diversification”, consider what it means and what types there are.

Diversification - what is it in simple words

Diversification (diversus “diversified” + facere “to do”) is the distribution of your capital between different investment instruments. For example, currencies of different countries, bank deposits, stocks, bonds, commercial and non-commercial real estate. Even the money you lend as collateral at interest. There are a huge number of assets in which you can invest.

Please note: Diversification is investing in different projects in order to minimize the risk of losses. The concept is used in production, economics, and banking.

To better understand what it is, I propose to consider a household example of diversification. Parents, trying to ensure that their child develops in different directions and has a broad outlook, put a lot of effort. They send him to different sports clubs and sections to increase his physical activity. They pay for tutors and additional lessons so that he can gain maximum knowledge. They enroll in theater and music schools, so he became familiar with beauty. All these events help them invest money in the future of their child, and in more than one direction. That is, the family does not rely on playing basketball, for example, but chooses different development paths, because they are confident that the skills acquired by the child will pay dividends in the future.

Another simple example: Ivanov and Petrov decided to transfer their equivalent cash savings into securities by purchasing them on the stock exchange. Ivanov chose one company, investing everything he had in it. And Petrov – three. Based on the theory of probability, we can assume that Petrov, in comparison with Ivanov, has reduced his risks of incurring losses by three times. Let us remember the popular wisdom that you cannot put all your eggs in one basket. It clearly explains Petrov’s tactics when buying shares.

Definition of a concept in simple words

The term diversification comes from Latin words that mean the following: Diversus - different, Facere - to do, that is, “to do differently . There is a synonym for this word "diversity" . In simple terms, diversification is a risk management strategy associated with the rational allocation of available resources to minimize losses. It means increasing the range of manufactured goods, improving the sales market, organizing new production units, investing simultaneously in several types of business, choosing multiple sources of income, and more.

Diversification is used in different ways today:

• in the economic sphere;
• in business activities;
• in production;
• in the field of finance;
• investments.

What can you diversify?

In theory, diversification helps optimize any line of business activity. But what is it used for in practice? The main goal is to reduce investment risks.

Important: Investing is a high-risk activity. At the same time, each investor strives to obtain maximum profitability with minimal risks. Diversification is a tool that solves the second problem.

How can you diversify your investments? There are several ways:

• Diversification by currency is a classic option when you divide all your money into three boxes. Store rubles in the first, dollars in the second, euros in the third. Thus, you protect yourself from the risk of devaluation of the ruble, depreciation of the dollar relative to the euro, etc. That is, your capital will be stable over a long period of time.
• Diversification by country - when you invest money in the assets of companies in certain countries. If you have ruble savings, you invest them in Russian projects. If they are in dollars, then in American ones. You send the euro to the eurozone, buy some shares and bonds on the European market.
• Diversification by assets - when your portfolio does not have one thing. For example, 100% shares, even if these are shares in different countries and currencies. There are a huge number of assets that are now available to almost any investor. A classic portfolio should consist of 5-10% gold, 5-40% cash. The rest is stocks and bonds in different proportions.
• Precious metals diversification – when you invest in gold, platinum, silver, etc. Suitable for unstable and crisis situations.

Let's analyze the use of this tool in a little more detail.

Looking by decade

Few investors have a 46-year window to empirically test the effectiveness of their strategy. Most investors have less than five years of investment experience, and this does not even cover a full business cycle.

In the behavioral finance literature, one of the common cognitive errors of investors is the recency effect, that is, the tendency to emphasize the recent past when forming expectations about the future. Thus, an investor's short personal experience usually trumps historical data.

To make the results of our test look more down-to-earth, let's look at the results of the portfolios by decade. For each decade, we will calculate the nominal and real returns of the portfolios and the three pillars. Real return means that we subtract the risk-free rate from the results. The latter is usually taken to be the yield on three-month Treasury bonds.

Real yields allow us to evaluate performance more effectively, given that different decades have seen vastly different interest rate environments. Let's face it, a 7% yield in a market where short Treasuries are yielding 6% is not as attractive as a 5% yield with a 1% risk-free rate.

The 60/40 portfolio, at the same time, brought in 9.2% per annum, which means that broad diversification reduced the strategy's return by 0.28 percentage points. And 2022 turned out to be the most dismal year for the diversified strategy. On the rebound after the March collapse, the 60/40 combination gave 15.4% versus 9.5% for a portfolio of 16 instruments.

Diversification performed poorly due to the assets of the third pillar, whose nominal return totaled 4.4% per annum. So, if the 2000s are called the lost decade for stocks, then the 2010s can easily be called the lost decade for diversification.

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Gold is needed to stabilize your portfolio because, in theory, it will rise when the rest of the market falls. But many times in history I have seen examples that this precious metal can also fall. In fact, its advantage is that after some time, while the market is still stormy, gold assets will already begin to grow.

Bonds , unlike stocks, are a fixed income instrument. In a sense, they resemble deposits. You buy a bond, hold it, and the issuer is obliged to pay a coupon - a pre-agreed percentage of the purchased bond - with some regularity. It doesn't matter what the bond is worth on the market right now. If you hold it until maturity, then you are paid the full value. Having a bond in your portfolio also reduces risk and increases diversification.

Shares allow you to diversify across countries, sectors, etc. When operating within one specific sector, I do not recommend buying just one type. There is always the opportunity to choose several. A good option is when you purchase an entire ETF for a sector (energy, healthcare, IT, etc.).

ETFs are a powerful tool for beginners. On the one hand, it is very simple. And, on the other hand, it gives the maximum diversification effect. You don’t need to choose a bunch of companies, analyze them among themselves, think which is better and which is worse. Instead, you simply buy an ETF that already has a bunch of companies in it. When there are many organizations, some of them will go up, some will go down. But, in general, the volatility of such instruments is small - there will be no sharp jumps. But they help protect yourself from a strong decline in assets.

Please note: This is the essence of the risk diversification method. You distribute funds between different assets and instruments, based on what goals you want to achieve.

Financial Risk Management

The principle of diversification is directly related to increasing the sustainability of the enterprise. In this case, it is possible to take less into account the level of income received. When specialists conduct the appropriate analysis, the enterprise’s resources are distributed in various areas that are absolutely unrelated to each other. Here, both the stability and profitability of each direction are taken into account.

It is possible that certain parts of the market will have lower margins, but reliability is more important. This principle is actively used by investors who distribute investments in such a way that the portfolio is as reliable as possible.

Why is diversification a very useful tool?

The main goal of diversification is to minimize risks, no matter what specific industry. It allows you to obtain economic benefits, as well as prevent a decline in production and preserve assets in crisis situations. Among the main advantages I can highlight:

• security of your funds even in times of crisis or market instability;
• the ability to distribute capital in order to optimize some activity;
• increasing competitiveness, which involves expanding sales markets;
• attracting additional assets to improve lagging areas of work.

Here I propose to consider the rules of diversification. The first is to start as early as possible. The point is, don't wait until your portfolio gets big before you start diversifying. From the very beginning, as soon as you start investing, think about what it will look like. How many shares, bonds, precious metals, etc. will it contain? Next, based on the framework that you have imagined in your head, start filling your portfolio step by step. Then you won’t get confused, and you won’t have unnecessary temptations, for example, to allocate more to stocks or not leave any cash at all.

The next rule is to maintain portfolio balance. What I mean by balance is this: you divide the portfolio into several segments (metals, cash, stocks, bonds) and then start looking inside each of them, because there will be diversification there too. If we look at precious metals, there may be gold, platinum, and palladium. And each of the elements must be presented in the proportions that you have determined for yourself in advance. If we are talking about stocks, then I recommend not holding more than 5% of each issuer. Even if some company is very good, you like it very much, you should not bet on it. Let its shares in your portfolio be the same as others. This is the essence of diversification.

Another rule is portfolio rebalancing. When the portfolio is full, and after some time it begins to grow, then the shares of some shares increase in monetary terms. Let's say you have 10 thousand dollars. You filled 20 companies with $500. A year later, the company whose shares you bought for $500 doubled in price, and now its contribution to your portfolio is no longer $500, but $1,000.

Please note: At such a moment, it makes sense to restructure the portfolio: sell some shares and use them to buy some sagging companies that you also believe in. Such rebalancing should be done every six months to a year. This is one of the key points of proper diversification.

Examples

To better understand the importance of diversification, let’s look at examples from global and Russian practice.

You don’t have to look far to find positive diversification experiences. Thus, one of the largest Bryansk companies for the production and sale of food products, Factory Kitchen, further expanded its business by entering a completely new market for itself - real estate. The activities of such unrelated industries showed themselves to be successful: the crisis in the real estate market was compensated by increased sales in the food trade sector.

Let us also give an example of vertical diversification. The Czech company Studentagency initially engaged in bus transportation only for local purposes. However, it subsequently expanded its activities, affecting Slovakia, Germany, and Austria. Today, the company has diversified its activities by organizing excursions and booking hotels.

An example of an expansionary strategy is the diversification of activities by Salomon. It was initially engaged in the production of ski bindings, in which it was a recognized leader. However, it subsequently expanded its activities into the cross-country skiing footwear market and then into skis and golf clubs. This offensive strategy allowed the company to strengthen its activities and implement its own know-how.

Possible problems with diversification

What are the challenges in diversification? Firstly, it is difficult to keep track of a large number of papers. Secondly, you focus on quantity rather than quality, which dilutes profits. Warren Buffett spoke about this back in the late 1990s.

He noted that diversification as a practice generally makes very little sense to anyone who understands what he is doing. It functions as a kind of protection against ignorance. Of course, there is nothing wrong with wanting to be confident in the safety of your investment. This is a wonderful and healthy approach for those who do not know how to analyze a business. But if you know how to use analytical tools and evaluate businesses, then it's crazy to buy shares of 10, 20, or 30 companies at once. Because such a large number of successful (in the sense of being able to generate investment profits) companies simply do not exist. And the decision to invest in shares of a company that is number 30 or 35 on your list of attractive companies, and at the same time refuse to invest heavily in the leading company, looks strange.

Main problems of diversification:

• the complexity of budgeting and planning, phased development of all areas of activity;
• impossibility of keeping all investment objects under control;
• high probability of investing in unprofitable enterprises;
• difficulties associated with synchronizing work.

Important! Experienced investors consider this investment policy ineffective. Its result is always the achievement of exclusively average values. This can save you energy and reduce the risk of losses. But it can also be evidence that you don't really understand the businesses you own. Owning shares of 3 companies is more than enough to feel great throughout your life. However, when you are an inexperienced investor, it is difficult for you to immediately understand all the nuances.

Strategies

The diversification strategy involves opening new areas of operation of the enterprise that differ from existing ones. This is primarily a marketing action. Funds are distributed between various areas of activity, which reduces risks. The importance of choosing the right strategy is evidenced by the fact that it helps reduce the likelihood of enterprise bankruptcy.

Traditionally, there are three types of strategy:

• conglomerative;
• centered;
• horizontal.

The first strategy – conglomerate – is the most complex of the existing ones. With this type of strategy, the production of goods and services is not associated with the old line. Thus, it involves the development of new markets.

With the centered type, the company is looking for new opportunities to expand production, based on existing capacities. In this case, new production lines are launched based on existing experience. The achievements of previous product releases are taken into account. The new line operates separately from the old one.

In the case of horizontal diversification, a completely new product is created that is in no way related to the previous one. At the same time, it is necessary to master new technologies. In this case, a product is created that is not related to previous releases. However, to implement it, tools that are already available are often used. New types of goods are intended for consumption by the main product, or should become an accompanying product.

In the field of economics

Economic diversification is applied by government units, using strategic capabilities and resources of countries and global associations. Millions of people are involved here, the emphasis is on the coordinated interaction of government agencies, legislation, and existing management systems.

The main direction is to develop, first of all, human resources, the formation of generations that look to the future and have fresh ideas in the field of technology, science, and culture.

Constant adherence to this principle will form a strong, well-developed, progressive state. It also has a significant drawback - regular fulfillment of the conditions will require enormous resources, and real success is only possible with continuous movement.