We have all heard that diversifying means “not putting all your eggs in one basket”. The idea is to reduce the risk: “this way, if one basket falls, they won’t all break”. Although this is a simple way to understand it, diversification is much more than that.
Actually, diversification is a concept that derives from the Modern Theory of Investments, initially proposed in the 1950s by the economist Harry Markowitz, who won the Nobel Prize in Economics.
In his doctoral thesis, Markowitz argued that instead of measuring the risk of each individual instrument, investors should assess the risk of their entire portfolio. In this way, decisions about the purchase or sale of a particular instrument should be based exclusively on the impact that said decision will have on the risk of the entire portfolio.
This means that diversification is not just incorporating different assets into a portfolio. It must be done intelligently, in a way that controls risk and maximizes return, given the maximum level of risk an investor is willing to take.
The idea then is to have assets of different types in our portfolio that behave differently depending on market cycles and that also have different risks. For example, the shares of leading companies tend to increase in value during times of economic expansion, but not so much in times of recession or great uncertainty, when they tend to collapse. Debt instruments in certain cases behave differently and although in many parts of the world they pay yields below inflation, they can offer stability to our portfolio. In times of high inflation, some assets such as real estate (which also produce rental income) or gold are considered as a protection that allows us to counteract this phenomenon.
When one builds an investment portfolio, one incorporates these three major asset classes, which behave differently (when some go down, others tend to go up and thus counteract the volatility –or risk– of our portfolio).
The key, then, is to find the combination that is right for our investment horizon (investing long-term – for our retirement – is not the same as investing to buy an apartment in five years) and our tolerance for risk. There are people who get very nervous when they see a small decrease in the value of their portfolio, there are those who can tolerate very sudden situations that sometimes occur in the markets without blinking, because they have a broader vision.
Risk tolerance, by the way, is a variable that changes over time and depends on many factors: our age, our experience, the way we assimilate it. That is one of the reasons why we will have to adjust our portfolio over time.
Thus, diversifying means carrying out a careful asset allocation process, taking into account the level of risk we want to assume. Thus, we must determine what investment percentages we want to allocate to each asset class and in which markets (one must have a global vision, investing in both developed and emerging countries). Once this is done, then it will be convenient to look for the specific assets, representative of the different asset classes and markets, that will make up our portfolio.
It is important to understand that, although diversification allows us to control the risk of our portfolio, it does not eliminate it completely. It is true that there are high-risk and very low-risk assets, but there is no such thing as a completely risk-free investment. We must always be clear.
On the other hand, it is also possible to unnecessarily over-diversify and complicate a portfolio, which, paradoxically, can end up increasing the total risk. It will have to be taken into account.
Personal Finance Coach
Senior executive in insurance and reinsurance with strategic business vision, high leadership, negotiation and management skills.
He is also a Personal Finance columnist in El Economista, Personal Finance Coach and creator of the page www.planetusfinanzas.com
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Diversification is the key to any investment strategy