What is diversification and why do investors need it

What is diversification

This is investing in various financial instruments, sectors of the economy, countries and currencies in order to reduce risks. It is important that parts of the portfolio react differently to the same events. So the increase in the value of some assets will help not to notice the fall in the price of others.

Let's say an investor bought two ETF at the end of April 2021: one for US tech companies, the other for gold. The person believes in the growth of shares, but decided to play it safe: as a rule, the price of the purchased assets changes in opposite directions - if the shares are growing, then gold falls, and vice versa.

In two weeks, tech stocks lostProfitability information FXIT, 29.04.2021–14.05.2021 / FinEx 7% of its price and gold has risenInteractive chart of the value of the share "VTB - Gold Fund", 04/29/2021 - 05/14/2021 / VTB Capital by 3%. Investments were still reduced by 4%, but thanks to diversification, some of the losses were recaptured.

Diversification does not guarantee that an investor will avoid losses. But this is the most important component that reducesG. P. Brinson, L. R. Hood, G. L. Beebower. Determinants of Portfolio Performance / Financial Analysts Journal investment risk and allows you to achieve long-term goals.

How diversification helps you avoid losing money

The degree of diversification depends on the goals and characteristics of each investor. But the approach itself has several universal advantages.

Eliminates the risk of investing in one country, sector or company

If an investor distributed money among assets from different countries, then he insured himself in case of economic or political problems. For example the fallChina Shanghai Composite Stock Market Index / TradingEconomics Chinese stock market 10% per month will be unpleasant if the portfolio contains stocks of companies only from this country. But when such firms account for half of the investments, and the second is invested in the index of American companies, then a person in the end even earns a little.S&P 500 Index / TradingEconomics.

Reduces asset volatility

An investor can build a portfolio so as not to take too much risk due to hesitation prices, but worthy of earning. A textbook example is the effective Markowitz frontier, which shows the risk-reward ratio for several combinations of stocks and bonds.

Helps to build a portfolio

A diversified portfolio is likely to be less profitable compared to one or two investments in something fast growing. But the risk of losing money is also lower.

Allows you to quickly recover from the crisis

If you correctly distribute funds between different assets, then in a crisis the portfolio will lose less and recover faster.

Let's say two people invested $ 1,000 in January 2020. Crisis due coronavirus investors hardly foreseen. The first bought only a fund of American stocks, and the second insured himself: for 600 dollars he bought the same fund, and for another 400 - Treasury bonds.

The first investor eventually made a dollar more, but only at the very end of 2020. And I was much more worried: the diversified portfolio sank by a maximum of 5.67%, and of stocks - by 19.43%.

It is important to understand that diversification will help protect oneself in times of crisis, but will not insure against a tremendous fall, as, for example, in 2007-2009, when almost all assets were lost in value. To get out of a serious crisis in the black, you need hedging. This is a complex method: professionals select instruments with a correlation of -1, that is, those that move in the opposite direction from the market.

How an investor can diversify a portfolio

The investor has many options for hedging, the specific set depends on the investment strategy. But there are several simple and accessible methods for everyone.

By asset class

The classic approach to diversification is to distribute investments among four main asset classes. Everyone behaves a little differently, the level of risk is also different:

1. Stock. The value of a share in a company directly depends on the success of the company, its position in the market and the global state of the economy. It is difficult to predict future achievements or failures, so stocks are volatile: they can grow well, or they can collapse by tens of percent.
2. Bonds. Companies and governments decide to take debt when they feel they can repay it. Therefore, the profit is easy to calculate, and the price does not fluctuate much. Investors are paying for this with low returns, which are only slightly higher than inflation.
3. Cash. They do not generate income by themselves, because of inflation they even lose value. But in the event of a crisis, cash is valuable, since it can be used to immediately buy other cheaper financial instruments.
4. Alternative assets. This category includes everything that did not fit into the previous ones, from real estate and precious metals to agricultural land and collectible whiskey.

Investments between these classes will already provide good diversification. For example, a private investor can easily buy four funds and not worry about the classes: SBGB (state bonds RF), FXMM (short US Treasury bonds), FXUS (US stocks) and TGLD (gold-backed fund).

It also makes sense to choose funds because they are an additional bet on many securities. There is no ideal number of them, but there is convincing data.M. Statman. How Many Stocks Make a Diversified Portfolio? / The Journal of Financial and Quantitative Analysisthat it is better to distribute investments between at least 18-25 assets.

But the investor can distribute investments even further: choose between companies of different sizes, invest in shares of promising firms or, conversely, undervalued, buy ten-year or three-month bonds.

By sectors of the economy

The stock market is usually dividedThe Global Industry Classification Standard (GICS) / MSCI into 11 sectors, each of which is subdivided into industries. All sectors have their own characteristics: let's say IT mainly consists of fast-growing companies, and industrial - of those that pay generous dividends. The utilities sector is considered defensive because it is not particularly prone to crises, but the selective goods sector is cyclical, as it grows well only after crises.

When some sectors rise, others fall, and still others do not change. An investor can create a balanced portfolio of securities, taking into account the characteristics of different industries.

For diversification, a person can invest in industry funds. For example, AKNX invests in the top 100 technology companies stock exchanges NASDAQ, TBIO - in shares of biotech corporations, and AMSC - in semiconductor manufacturers. An investor can also choose companies separately: most Russian firms and major foreign corporations are available on the Moscow Exchange, and about 1,700 foreign companies on the St. Petersburg Stock Exchange.

By country

Each has its own economic and political characteristics: technology companies are strong in the United States and China, and in the European Union it is important to take into account climatic regulation. Investing in firms from different countries will allow you to choose the strongest industries and protect yourself from risks within one state. For example, due to internal political problems, China's IT sector lostDown $ 831 Billion, China Tech Firm Selloff May Be Far From Over / Bloomberg around $ 820 billion since February, and U.S. tech companies have addedXLK Market Cap / Yahoo Finance one and a half trillion.

In addition, countries are divided into developed and developing countries. In the former, which include, for example, the United States and Great Britain, it is more profitable to invest in the middle of the business cycle or shortly before the crisis. The latter, for example China or India, perform better during global economic growth.

For country diversification, it is easiest for a private investor to choose an ETF: FXDE invests in large German companies, FXCN - in Chinese, and SBMX - in Russian.

By currencies

As a rule, investments in companies from different countries automatically guarantee diversification by currencies - after all, one corporation earns in dollars, another in rubles, and the third in yuan.

But if the investor does not see attractive firms for investment or is expecting an imminent crisis, then the person is better off distribute cash in different currencies. Suppose an investor lives in Russia, but considers the Chinese market to be promising. But while a person is not ready to invest there: the Chinese Communist Party is raging with regulation, and the situation is similar to the pre-crisis one. It would be reasonable for an investor to leave some of the money in rubles, transfer the other into yuan for purchasing assets at a suitable moment, and a little more - in dollars and euros just for safety net.

How to combine diversification and investment strategy

If a person does not have investment strategy, then it makes little sense for him to engage in diversification. Without a strategy, it is difficult to assess the optimal balance of risk and reward.

If all this is clear, then you can start combining assets. There are many approaches, one of the simplest is “modern portfolio theory”. Its authors suggestE. J. Elton, M. J. Gruber, S. J. Brown, W. N. Goetzmann. Modern Portfolio Theory and Investment Analysis, 8th edition investors should start from just the term and the ratio of risk and return.

The general rule of the strategy: the shorter the investment horizon, the more conservative assets should be kept in the portfolio. The longer the period, the more risky.

Based on this, the authors of "modern portfolio theory" offer several templates that an investor can take note of.

There are a few things to keep in mind:

• The portfolio needs to be rebalanced. Market instruments are constantly changing in price, so you need to monitor the shares of assets in the portfolio. If in six months the shares soared by 50%, then you need to sell part and buy other assets in order to restore the original shares. Or revise the investment strategy.
• Any model is just an example. It is not necessary to buy US stocks, but bonds can be replaced, for example, shares in the real estate fund. The exact mix of assets again depends on the investor.

What is worth remembering

1. Diversification is a way to spread investments so as not to lose money due to the problems of one company or a crisis in one country. The key principle is "don't put all your eggs in one basket."
2. The investor can diversify the portfolio by class and number of assets, country and currency.
3. There are many approaches to diversification, one of the simple ones is to take into account the investment horizon, desired profitability and risk tolerance.