More than one investor embarking on an adventure into the world of finance should become familiar with the phenomenon of diversification. Although the overtones of the word indicate a certain complexity, the process of diversification itself is even a banal investing motto, which can be shortened to one saying—not all eggs in one basket.
In practice, this means that the object of our investment should not consist of only one financial instrument. So, if we invest money in asset A, then part of the invested amount should be allocated to asset B. The greater the distribution of the investment portfolio, the greater the level of diversification.
Just that much, or as much?
The aimless and thoughtless distribution of capital across assets misses the intent of diversification. The main idea behind the process is to spread risk by splitting investments into multiple components. Building such a portfolio is not a simple challenge, as it requires a thorough study of the market in terms of its relationships. It is through the interrelationship of assets (correlation) and instruments with the market (beta) that investors equip their portfolios with the diversification tool.
A practical example:
An investor invests $100 in shares of company X. Another $100, he invests in government bonds. The last part of the money ($100) he allocates to an investment in gold.
At the first bumps in the market, the shares of company X fall by half, government bonds fall by $20, and gold appreciates in our portfolio by $70. Consequently, it is very easy to see the diversification mechanism at work, which even offset the effects of the market turmoil (a total of -$70 on stocks and bonds and +$70 on gold).
If one were to invest money only in bonds, one would suffer a loss. The situation is similar with shares of company X. On the other hand, investment during this period and under such conditions in gold is pure profit! However, who, in practice, can predict market tumbles and forecast the future, surely has already sold his patents in more than one financial guide or podcast and has invested in a Hawaiian resort himself. We, on the other hand, still need a correlation coefficient for well-constructed diversification.
This is a common measure that indicates the direction and strength of the effect of one asset on another.
- The closer to 1, the greater the correlation of assets. The selection of financial instruments with a correlation greater than 0 is not conducive to the phenomenon of diversification.
- An index of 0 indicates indifference, i.e., if asset A increases or decreases, B remains insensitive to these changes.
- The closer to -1, the greater the correlation of instruments in opposite directions. This even represents a utopian situation in which the directions of asset changes are opposite to each other. This is a desirable phenomenon in a properly diversified portfolio.
Wise investing is not a reckless entrustment of intuition, let alone playing on emotions. It’s an analytical process that is more like “watching paint dry or grass grow. If you want excitement, grab $800 and head to Las Vegas. “P. Samuelson