04. The benefits of diversification
If you’ve thought about investing, you’ve heard of the word diversification. Not putting all your eggs in the same basket – which is, in essence, diversifying – is one of the basic rules of investment that we have explained to you. In this article we want to delve a little deeper into this concept and give you some examples.
The first thing you should know is that diversification is considered a defensive investment strategy. As we have said on other occasions, it is very difficult to choose the investments that will have the best results in the future. Therefore, it is more useful to think about how to limit our losses than how to maximize our profits. Diversification is about doing the former.
So, diversifying is about reducing risk… but which one? We usually talk about two types: systemic or market risk and non-systemic risk. Systemic risk is one that affects a wide variety of sectors. The sources of systemic risk range from inflation to wars to pandemics… It is not easy to protect against these types of events.
Non-systemic risk is one that affects only some sectors, types of assets or companies. For example, a regulatory change on vehicle emissions will mainly affect car manufacturers. The dismissal of a senior executive will affect the company concerned. And the emergence of a new competitor can affect the rest of the companies in the sector in which it operates.
Diversification combats non-systemic risk , that is, in the face of news that affects different companies, sectors or assets in different ways. That’s why diversification only works when we choose investments that have a low correlation with each other. For example, stocks and bonds. But also emerging markets and advanced economies…
There are many ways to diversify our investments. Here we tell you the three main ones.
Diversify by asset type
If you have taken your first steps in the world of investing, it is likely that you have invested in equities (stocks) and fixed income (bonds) through an investment fund. If so, you have already diversified your investments: the typical fund consists of a portfolio composed of around 60% stocks and around 40% bonds. Stocks give more long-term returns, but they have a lot of volatility (their value is very changeable). Bonds yield less but are more stable.
The combination of stocks and bonds is also a good idea because they behave differently. Usually, when the economy goes into recession, stocks go down. When this happens, central banks usually lower interest rates, to boost the economy, and bonds go up – although it doesn’t always happen. The best way to diversify into both types of assets is through index funds .
You can further diversify by adding more asset types to the mix, such as commodities, precious metals or real estate. Burton Malkiel and Charles Ellis, two experts with proven track records, recommend avoiding complexities and making real estate the third ingredient in our diversified portfolio. And in the most direct way possible: living in a house we own. Although there are more alternatives, such as real estate crowdfunding…
Diversify by markets
Just as not all sectors react the same to economic news, neither do they affect all countries equally. Think, for example, of Australia. Before covid, the effect of which was universally negative, this country had gone no less than 30 years without experiencing a recession.
Without reaching examples as rare as the Australian one, it is always a good idea to distribute our investments in different geographical areas. Again, the easiest way to do this is through actions. Many companies operate in different countries and, in a way, already have diversification built in. But it’s safer to broaden the focus and invest in an entire index, such as the S&P 500. Although there are also indices, such as the MSCI World, which includes companies from all over the world and therefore offers a lot of diversification.
Diversify over time
Perhaps the most important and least applied rule is not to make all investments at the same time. The reason is simple: the chosen moment may not be the best. When we talk about stocks and funds, there is a clear trend: people tend to chase past performance by investing in hot sectors or companies .
It is a wrong strategy, for several reasons: the first is that past performance does not guarantee future returns. As we know, we must look at the long term and avoid hasty decisions, which follow one or another trend. Another reason why it is not a good idea to invest in fashion sectors is that it is usually expensive: stocks are expensive, and the more expensive we buy, the lower the future profit.
What to do? The best strategy is to invest small amounts periodically. In this way, we will continue to benefit from compound interest and, in addition, we will buy fewer shares when prices are high and more when prices are low. This technique, which is known as dollar-cost averaging , is, in fact, the most profitable in times of great volatility.
Diversify in real estate
If you decide to add real estate to your investment portfolio, real estate crowdfunding is one of the options that allows greater diversification. By requiring small amounts, you can invest little by little, periodically. As in Urbanitae, it can be diversified by developer, sector (commercial, residential …), time, strategy (loan, capital gains, rents) and location. In addition, in Urbanitae each project is independent of the rest: each one has its own company and separate accounts, which increases security for the investor.