What is the essence of capital diversification for investors?

Any income-generating activity cannot last for a long time unchanged. In order for your income to be sustainable, you need to think about reducing risks or diversifying capital .

Approximately 2/3 of the adult population of Russia have income from only one source – employment. Only one fifth of the population has 2 sources of income, of which the main thing is the same employment. Therefore, it is so scary to lose it. In the article on financial literacy, we wrote that your income can be considered sustainable when you have established 3 sources of income .

Those who come to trading , as an extra income, do the right thing – they connect another source of income to the main one. But even here it is worthwhile to secure at least three different trading strategies .  

You guessed it, why?

All right – the number 3 to sustainability. Three different strategies or tools are insurance for your capital.

If you come to trading seriously and for a long time, then first of all you need to protect yourself and diversify risks.

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Why is this necessary?

In itself, the definition of the diversification of finance in trading means protection against risks in different ways, insuring you to varying degrees from draining the deposit.

It is necessary that during periods of temporary difficulties or a long-term decline in income, you can maintain your usual standard of living and your activities in financial markets. Thus compensate for possible losses.

The principle of diversification of funds is applicable not only in trading, but also in any other business. For manufacturers – this is an expanded range of products in different price segments. That is, if possible, products should be of different types – if some expensive products become worse sold, then the losses from this trade should be covered by the income from the sale of other, possibly less expensive products.

When trading on a stock exchange, each newcomer must learn to work with three different tools with varying degrees of profitability.   I think you already understand why.

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Investment portfolio diversification

The vast majority of traders   work with stocks and bonds. But besides them, there is still real estate, precious metals and raw materials, foreign exchange trading. All instruments are divided into safe (for example, bonds), medium risk and high risk (precious metals, raw materials and stocks).

Common mistakes beginners

  • Often, beginners do not understand the essence of diversification. They think that if they buy shares of different companies within one country, this will provide them with relative capital security.
  • Another mistake is when they buy bonds of 2-3 different countries. The tool is all the same, what difference does it make in different countries?
  • The third is when they invest money in investment funds of companies or banks that provide the same types of investment services.

In order to protect its assets, the portfolio must consist of assets with different degrees of risk, different returns and correlation.

Stocks are one tool. Bonds are different. Real estate and gold – the third. Therefore, a portfolio of only stocks, or only bonds, is less secure than one in which there is both. And for reliability it is better that there is something else third.

Diversification is to ensure that in case of loss of profitability from one of the assets, the reduction does not affect other types of securities.

For example, when the economy goes into recession, stock prices change. At this time, interest on bonds continues to accrue. But with a sudden increase in inflation and the devaluation of currencies, stocks and bonds alone will not save you. It would be a wise decision to allocate some part of the portfolio for real estate or raw materials.

Or, for example, fuel prices are rising, and because of this, prices for transportation costs are rising. It is logical that the value of shares of transport companies may fall. If there are energy carriers in your portfolio, their rise in prices will be blocked by the drop in the share of transport companies.

One important point is that  diversifying any savings makes it less painful to endure a temporary hardship. But this does not mean that you will not lose money on transactions at all. In any case, you will lose some of the income from transactions on the stock exchange. But it will be limited to your risk management and competent diversification.

If you are a novice investor, then just remember – short-term losses are common in financial markets. All you need to learn to control them.