What is portfolio diversification

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

The main task of portfolio diversification is to reduce the risk of losing money. It is an investment in a variety of assets. At the same time, the purpose of diversification is also such a redistribution of own resources, which will allow maintaining or increasing the profitability of the portfolio. Various mechanisms are used to achieve these objectives. Among the main ones are the use of various types of financial instruments. For example, bonds and stocks. In addition, you can use different tools of the same type. An example is investing in shares of several organizations.

Types of risks

To carry out effective portfolio diversification, it is necessary to classify various risks first. As an example, it is proposed to consider the shares of a financial institution. The activities of banks are affected by the risks of several main categories. These include state, economic risks, as well as risks of the industry, segment or individual company. To understand the process of diversifying an investment portfolio, it is better to consider themmore details.

So, government risks are circumstances that can change the business climate in the country. As a rule, the reason for such changes is the adoption of new laws and other legal acts, as well as the nationalization of private property. In addition, revolutions or political upheavals can be attributed to harmful influences.

Economic risks are associated primarily with the macroeconomic situation. Instability in this area can be caused by financial crises, recession or stagnation. The risks of the segment include crisis phenomena on the stock exchanges. The risks of the credit and financial industry include interbank crises. In addition, there is always the possibility of bankruptcy of a particular bank. In this case, we are talking about the risks of an individual organization.

Diversification of different types of risks

Now you can consider in detail the mechanisms that allow you to diversify your portfolio depending on the class of existing threats. For example, in order to distribute state risks, it is advisable to divide one's own financial resources among several countries at once. This method is used by the largest players in the market. We are talking about international investment funds. Such organizations concentrate significant amounts of savings of individuals and legal entities and have ample opportunities for portfolio diversification.

To redistribute investments and minimize the impact of economic risks, it is advisable to use various investmenttools. For example, stocks and precious metals. During a recession and stagnation in the economy, the money resources of most investors drift into tangible assets. For example, in gold. With a fall in the value of shares, there is a possibility of maintaining stable prices in the precious metals market.

Diversification of stock risks

An effective mechanism for minimizing the risks associated with the situation on stock exchanges is the so-called beta hedging. It consists in including in the investment portfolio such assets, the trend of changing the value of which is opposite to the movement in the market. Also, to diversify the financial portfolio, you can use such a mechanism as the acquisition of different types of assets. For example, stocks and bonds.

Risks in a particular industry or company

To prevent industry risks use investing in different areas of the same type of assets. For example, shares of a financial institution. In this case, it is advisable to invest resources not only in bank securities, but also in other property rights. A good option is a parallel investment in shares of commodity companies. In addition, for even greater leveling of risks, securities of several enterprises operating in the same industry can be included in the portfolio at once.

Naive diversification

One of the most common mistakes novice investors make is going down the path of the so-callednaive portfolio diversification. What it is? It consists in buying shares or bonds of different companies without a preliminary analysis of the threat against which such a safety net is made. An example is the acquisition by an investor of securities of two or more oil companies. In this case, an attempt is being made to protect one's investments from falling prices for black gold, but a significant decrease in its value on world markets will inevitably cause a decrease in the price of the investment portfolio.

In other words, naive diversification of an investment portfolio is the type that is able to secure the investor's assets only in the event of the bankruptcy of a particular enterprise. But it will not protect against changes in the economic situation, which has happened very often in recent years. To minimize the risks of a subsidence of the entire industry, it is necessary to diversify capital between different sectors of the economy. At the same time, a good way to protect against declining energy costs is to include financial derivatives in your investment portfolio. For example, futures.

Diversify loan portfolio

The meaning of this variety lies in its distribution among borrowers who are characterized by a different amount of capital or form of ownership. In addition, when issuing loans, banking institutions take into account other conditions for the activities of business entities. For example, the branch of the economy and the geographical location of industries. Concerningshare three main types of loan portfolio diversification: portfolio, by industry and by geography.

Portfolio diversification

This type of distribution of capital involves the issuance of loans to a wide variety of categories of borrowers. These can be large and medium-sized companies, small businesses, individuals, government agencies or public organizations, households and other entities. For example, loans issued to small businesses tend to have higher returns. At the same time, they also come with significant risks. Small entrepreneurs do not have the opportunity to freely choose a lender. Therefore, banks can enter into transactions with representatives of the small business sector on their own terms. But loans issued to large companies have a lower yield, but the risks are also insignificant.

Industry diversification

This type involves the redistribution of the capital of a financial institution between borrowers who operate in different sectors of the economy. For effective selection, it is recommended to use statistical studies of specialized companies. A special effect in the sectoral diversification of the bank's loan portfolio can be achieved if you choose borrowers who carry out their business activities with opposite phases of the business cycle.

In addition, it is advisable to choose areas of the economy in which the performance of enterprises in this segment is not affected byserious influence of the overall economic situation. What does it give? When one of the industries is in the process of growth, the other may experience a recession or stagnation. It is likely that over time they will change places. In this case, the decrease in income from one category of borrowers will be offset by an increase in income from another group. In other words, conditions will be created to ensure the stabilization of the bank's income, which will significantly reduce risks.

Geographic diversification

It should be noted right away that this mechanism is often available only to very large financial institutions. They, as a rule, have an extensive network of branches and branches over a large territory. The meaning of such portfolio risk diversification is to issue loans to individuals and organizations that are located in different regions of the country and even several states. Non-identical economic conditions due to the wide geography of lending will minimize the negative impact of various factors.

In addition, different climatic conditions, political circumstances, the level of development of industry and production in a particular region also speak in favor of this type of diversification. It should be noted that small financial institutions can use this method. But mostly only during the creation of an investment portfolio, which makes it possible to reduce the overall riskiness of the bank's activities.