The term “diversification” consists of the words diversus and facere, which together mean “do different things”. In trading, if we talk about diversification in simple words , this means the distribution of investments with the greatest profit and minimal risks in assets with different returns.
It seems difficult, but in fact we meet with this phenomenon in other areas of life.
Example 1 – when a girl gives out advances to several boyfriends at once, not because she is windy, but to hedge and in case something happens, not to be lonely. By the principle – not one will call in marriage, so another.
Example 2 – experienced bank depositors place their savings in several banks. If one bank fails, then some of the money will be saved on deposits with other banks.
The goal of diversification is not only to minimize risks, but also to increase profitability at the expense of complementary assets.
But the realities of current financial markets are such that it is harder to predict the expected growth or fall in asset prices.
- its use complicates the process of deposit management, since capital has to be distributed among different assets;
- Because of this, its concentration in the most profitable areas has to be reduced;
- the development of new unfamiliar assets increases the likelihood of possible losses.
But the worst thing is that, with all the obvious disadvantages , it is even more risky to focus on only one type of asset than to diversify your investment portfolio.
The concept of diversifying the investment portfolio includes a set of different securities that belong to the same owner. The package includes stocks , bonds, currency and others.
Ideally, the portfolio should consist of securities with different yields and different degrees of risk. Moreover, the more different types of securities in the portfolio, the lower the risk of your investments.
Since the stock market has its own characteristics, in drawing up a portfolio, one should pay attention to the following signs:
- profitability – see here that securities provide you with acceptable interest rates, since the variety of securities alone does not guarantee you their value and real profitability;
- the concept of sectoral diversification — small-scale crises and other difficult predictable circumstances can influence not only the stock prices of individual companies, but also entire industries;
- classes or groups of assets — that is, stocks, bonds, currency, precious metals, and so on. As an example, in 2008, at the first wave of the crisis, the lucky owners of large sums in foreign currency and precious metals kept afloat. Holders of other assets suffered significant losses. therefore, it is necessary to compile a portfolio of different types of assets;
- various territorial factors — the size of a stock or currency is influenced by the economic and political situation in the country of origin, natural disasters, wars, and mass unrest. Therefore, in your portfolio should be securities issued in different countries;
- mutual correlation independence – in simple terms, investing in securities of related enterprises is a more risky process than investing in projects that do not depend on each other. For example, it is undesirable to invest in a construction company and enterprises that produce cement, brick and other building materials. It is better to invest in enterprises of different industries, in which case your income is minimally affected by the crisis;
- the notion of diversifying deposits in banks means that it is highly undesirable to keep the entire amount of savings in one place, even if the bank offers super terms.
Trading and non-trading risks
All risks in trading are divided into trading and non-trading , which are not directly related to trading.
Suppose the risk of losing a deposit in the process of losing trades is a classic trading risk.
And if, God forbid, the trader lost his capital due to the fact that his brokerage company closed and left the market, taking all the investors’ capital, this risk does not apply to trading.
Risk diversification is a forced measure, but it is necessary to preserve capital and optimize income. Anyway, you are forced to divert to this a significant part of the resources.
The problem with choosing the type of diversification is that you will have to proceed from the composition of your portfolio and the specific market situation.
To conduct a full-fledged trade for a long time without the use of diversification is almost impossible.