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When the market is growing, it can be difficult to imagine negative developments. But as the situation in recent weeks has once again confirmed, you can never be one hundred percent sure of continued growth. The market can be influenced by various factors, including those that no one could have predicted.
Therefore, it is extremely important for any investor to think about portfolio diversification, which will balance risks and control possible losses. Our new material contains 5 tips for creating a diversified investment portfolio.
What is diversification
Simply put, diversification is an approach in which an investor builds a portfolio containing various financial instruments.
Diversification involves creating a portfolio that includes a wide range of different financial instruments and asset classes. This allows you to reduce the unsystematic risk that arises when investing in a specific company - as opposed to the systematic risk that arises when investing in specific markets in general.
Here's what you should keep in mind when creating a diversified investment portfolio.
Risk optimization methods
Risk optimization itself is a labor-intensive but effective process, since it is necessary to periodically develop development scenarios and assess the future state of the enterprise and the environment. Risk optimization is preceded by special analytical preparatory work, the completeness, accuracy and thoroughness of which directly determine the effectiveness of its application.
Risk optimization methods refer to proactive management and strategic planning methods. Strategic planning includes studying the company's potential, forecasting the parameters of the external environment, periodic development scenarios and assessing the future state of the internal environment, predicting the actions of potential counterparties and competitors. Thanks to the results obtained, trends in the relationships between business units are recorded, timely preparations are made for changes in legislation, the necessary measures are taken to compensate for losses in the event of changes in management rules, and operational, strategic and tactical plans are adjusted.
Risk optimization methods:
- Limitation;
- Reserve funds.
The limiting method is the setting of limits on certain expenses, the sale of goods on credit, the amount of capital investments, etc.
Reserving funds to cover unforeseen expenses includes calculating the ratio of potential risks and the amount of costs that will be required to overcome the consequences of such risks. This risk optimization method is usually used when implementing various types of projects. Typically, the creation of reserves is necessary to finance additional work, to compensate for unexpected fluctuations in the cost of labor and materials, and overhead costs incurred during the implementation of the project.
It is important to use different types of assets
The key idea of the concept of diversification is that you cannot invest in one stock or in shares of companies in one sector.
Ideally, distribute investments between several companies from different market segments. At the same time, it is better for novice investors to invest in securities of well-known and reliable companies. It is important to remember that stocks are not the only investment instrument. There are ETFs, model portfolios, structured products, after all, in Russia you can open an IIS account and receive a tax deduction.
At the same time, it is important to keep a balance. The investor must create a portfolio that he can actually manage and control. There is no point in buying 100 different stocks and other instruments at once, if later you simply do not have enough time to even keep track of so many assets. 20 or 30 instruments in a portfolio is a reasonable maximum in this situation.
How to properly diversify your portfolio
The more diverse the resources in the portfolio, the easier and calmer the investor will be able to cope with a decrease in their value. Large-scale crises in the global economy happen extremely rarely, but problems in individual industries or organizations happen quite often. An experienced investor with a diversified portfolio can be confident that if a problem arises in a particular area, other investments will more than pay for the downturn.
Asset allocation strategy in an investment portfolio
The thoroughness of the approach to filling the portfolio directly depends on the experience of the investor and his investment temperament. At the same time, you should not blindly copy other people’s strategies - the optimal solution would be to take into account the basic model and its further gradual adaptation (to develop an individual approach to investing).
Proper diversification involves a variety of funds in foreign currencies (pound sterling, Chinese yuan, etc.), as well as the selection of assets from different areas and companies. By applying a similar technique, you will insure your portfolio against the negative impact of a fall in any one position.
The portfolio should contain low-risk (bonds) and high-risk (stocks) assets. The percentage of bonds in the portfolio depends on the age of the investor - for example, if the investor is under 40 years old, the portfolio may include 25% bonds and 75% stocks, and if the investor is over 40 years old, the ratio of bonds to stocks may be 40% to 60%. This strategy is due to the fact that a person’s risk tolerance usually depends on a person’s age.
Tip: Planning to buy 14 debt securities? In this case, it is best to choose securities from seven areas of the economy - it is important that all corporations have approximately the same amount of deposits.
Step-by-step instruction
We offer a step-by-step analysis of portfolio diversification with a capital of 500,000 rubles.
Procedure steps:
- Transfer of a certain part of income into foreign currency - for example, 30% of capital can be invested in foreign assets (it must be remembered that the dollar and ruble portfolio are diversified separately).
- Buying Bonds - If the investor is 33 years old, bonds could be around 30%.
- Investing the remaining amount in shares - select from 10 to 14 organizations from 6-8 areas, and invest in them (the share of each asset in this case will be from 18,000 to 25,000 rubles).
We have presented a classic simple method of portfolio diversification. In practice, capital may imply the presence of real estate, precious metals and other resources. When choosing assets, it is necessary to take into account their potential profitability and risks.
Tip: Don't have a lot of money? Then for successful diversification it is worth consulting with experienced specialists. If you have several hundred thousand rubles, you should choose several areas (for example, currency and stocks), and after your first income, gradually expand the area for deposits.
Indices are a good option for diversification
At its core, an index is an indicator of price changes for a certain group of securities.
Roughly speaking, this is a “basket” of shares united on some basis. The set of securities included in the list on which the index is calculated determines what information can be obtained by observing the dynamics of this index. Typically, the purpose of compiling a stock index is to create an indicator with which you can understand the general direction and “speed” of movement of stock quotes of companies in a certain industry.
For private investors, investing directly in indexes is not a realistic option, since they include many companies whose shares can be expensive. To use the conditional S&P500, you will need to buy shares of all companies in the appropriate proportion, this requires millions of dollars.
In order to use indices without the need for such huge investments, the ETF (Exchange Traded Funds) tool was created. In essence, these are foreign exchange-traded investment funds, which represent a portfolio of shares or other assets that completely replicate the composition of the target index. For example, an ETF with the ticker SPY reflects the performance of stocks in the S&P500 index. Shares of the ETFs themselves are also traded on the exchange.
Risk avoidance and risk diversification
Avoiding risk is the easiest way to avoid it. This method is used by companies that have a strong position in the market and whose managers prefer to avoid risky projects and unreliable partners.
Risk diversification means the distribution of capital investments between activities that are not directly related. Thus, if a company incurs losses in one activity, it can close it at the expense of profits in another activity. You can reduce the risks of business by diversifying as follows:
- Expanding areas of activity by increasing the number of technologies used and expanding the range of products and services offered;
- Increase the number of suppliers of raw materials and components, thus reducing losses due to the unreliability of some suppliers who violate delivery schedules or deadlines;
- Expand markets by working in several markets simultaneously and targeting different consumer segments or regions, etc.;
- Diversify the investment policy, giving preference to several projects with relatively low capital intensity or investing capital in different types of activities, different types of securities.
It's always worth keeping an eye on commissions
When investing on the stock exchange, costs are not limited only to the cost of the acquired assets.
The exchange and brokers take their own commissions. Depending on your service rates, various subscription costs and additional fees may apply. It is necessary to analyze all your expenses when determining the profitability of your portfolio. Otherwise, it may turn out that a seemingly successful transaction turns out to be unprofitable in practice due to associated costs.
ITICapital tariffs are available via a link on our website, and there is also a convenient calculator for quick calculations.
To make transactions with shares and other instruments on Russian exchanges, you will need a brokerage account - you can open it online.
Read reviews, market analytics and investment ideas on the ITI Capital Telegram channel
Typical Diversification Mistakes
Due to a misunderstanding of the diversification mechanism, many novice investors make unfortunate mistakes.
List of the most common mistakes made by inexperienced investors:
- Selecting exclusively high-yield bonds - such a portfolio will be effective only in a bull market (a prolonged rise in prices affecting any sector of the financial market), and not in a crisis.
- Lack of protection from currency fluctuations - for a stable income, experts do not recommend choosing assets in only one currency.
- Insufficient diversification - for example, if an investor forms a portfolio worth 1,000,000 rubles, buying nine shares of one hundred thousand rubles and gold worth one hundred thousand rubles, then the percentage of protection of such a portfolio will be very small (if shares fall, the growth of gold will not compensate for the general decrease in price portfolio).
- Lack of country and industry diversification - to succeed, an investor should invest financial resources in various areas.
- Neglecting portfolio rebalancing - such an oversight can lead to a radical change in the asset structure.
Tip: Choose resources that are mutually correlated with each other - for example, when stocks fall, gold usually rises. Short bonds should be balanced by long ones.
What is an investment portfolio
An investment portfolio is a set of assets for accumulating and multiplying capital. It is similar to a wallet that stores:
- stock;
- bonds;
- ETF;
- foreign currency;
- precious metals, real estate, cryptocurrencies, etc.
The investor receives income in two ways: in the form of the difference between the purchase and sale prices of assets or in the form of periodic payments - dividends or coupons. Before compiling an investment portfolio, you need to formulate your attitude to risk, set a goal, and determine the time frame for achieving it.
How to build an investment portfolio
1. Clearly formulate the goal, since it depends on the period and amount of investment. For example, in a year you can buy a car for 1.5 million rubles or by the age of 40 you can achieve a passive income of 50 thousand rubles.
2. Determine your risk profile. You can take a test on the broker’s website or independently assess your tolerance for possible losses.
3. Allocate assets in a percentage that matches your goal, time frame, and risk tolerance.
4. Select securities. Before purchasing assets, you need to analyze their reliability and potential profitability.
5. Diversify investments. The portfolio had to adapt to market fluctuations, uncertainty and errors. To minimize risks, you need to invest money in different instruments, industries, countries and companies. This way, individual investments will not significantly affect capital. If the investment amount is small, you can use exchange-traded mutual investment funds (ETFs) for diversification.
6. Monitor investment performance and regularly replenish your brokerage account. By checking your results, you can find and correct errors in a timely manner. Regular investments help reduce the average purchase price.
7. Rebalance your portfolio, that is, sometimes sell or buy securities so that they continue to meet the chosen ratio.
