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Finding a balance between returns and risk is a challenge investors face. That’s why diversification is a useful approach that any investor profile can follow.
In the financial world, investing arouses a lot of interest among lots of people, regardless of wealth or income. They all have the same objective: make returns from the market. But, as markets can be fickle, there’s no magic formula for bountiful investing. Risk is an important thing to consider when investing.
In the past, because investors generally focused on finding high-return opportunities, without too much consideration for risks, they often invested in assets that could cause them to lose all their money. In 1952, US economist Harry Max Markowitz revolutionized investing when he published an article arguing that risks and returns are equally important. He suggested an approach to help reduce financial risk: diversification. Markowitz’s momentous theories earned him the Nobel Prize in Economic Sciences in 1990.
In general, to diversify is to choose more than one thing; in investment, it means apportioning funds among various assets. If one asset takes a loss, the money invested in the others won’t be affected.
How to diversify investment well
Whether you want to start investing or already have experience, you should take some tips on diversification. First, you should choose investments based on the money you have available, expected returns, the risk you can afford to take and the time you’re willing to wait.
Let’s meet Tomás. In recent years, Tomás has been putting some of his wages in savings; now, he wants to invest. He aims at growing his money for retirement in 10 years. He has no hurry or need for liquidity, so he can make a long-term investment. Because he doesn’t want to take up too much risk, he looks for an asset that is safe, even if the returns are low. He can choose among these options to diversify his investment in a way that will help him achieve his goal and reduce his risk.
Invest in several assets
Market trends don’t have the same effect on a company’s share price, foreign exchange rates and property value. Allocating money to several types of assets would reassure Tomás that, if one loses value because of fluctuating prices, the others could remain unaffected or even stand to gain from it all. For instance, because a company could become more competitive abroad if its local currency loses value, its share price could rise and offset the losses on the investment in that currency.
Invest in various sectors
A common mistake is thinking that diversification means investing in different companies, regardless of their industry. That could end up badly, because if you buy shares in three companies in the same industry, new regulation, a natural disaster, rising production costs and other factors that could affect it will likely reduce the companies’ share value. Tomás has many options to combine investments in industries that aren’t directly related, like transport, banking, technology, property and manufacturing.
Invest in different markets
In general, people tend to invest in their domestic or regional market, as they seem more familiar and reliable. Still, it’s a good idea to diversify investments geographically by finding alternatives in countries with good economic outlooks. In that case, Tomás should consider things like inflation, political changes, economic legislation, and even natural disasters and armed conflict. It might be helpful to design an investment portfolio with an expert or investment fund. Investing in different regions can reduce risk like investing in different assets and sectors because economic ups and downs don’t usually affect all countries in the same way.
Diversify maturity lengths
One way to categorize investments is when they reach maturity: short term (up to a year), medium term (up to five years) and long term (more than five years). In general, the shorter the term, the lower the risk — but also the return. Long-term investments are expected to be high-risk but also yield a higher return. While diversifying maturity lengths helps reduce risk, investors must consider their own liquidity needs and expectations. Because Tomás hopes to retire and doesn’t plan to use funds in the short term, he could opt to invest in medium- and long-term assets.
The risk of over-diversification
Diversification without some restraint can harm an investor’s financial health. Too many diversified assets in a portfolio can lead to higher management costs and lower returns. Managing over-diversified portfolios demands more time, and it’s harder to know what’s happening in every industry or region to make decisions about assets.
