Even though we are not a big hedge fund traders this doesn’t mean that we could not create small portfolios and diversify them. In this way, if we invest relatively long term, we can split our investments in a way that we can be well protected and profitable at the same time.
Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some securities neutralizes the negative performance of others. With that strategy, you can mix a wide variety of investments in one portfolio and to yield high long term returns on average and lower the risk on any individual bad performing holdings and securities.
So, if we are talking about investment portfolio the first thing you should know is that you can make diversification by asset class.
The most commonly used are:
Of course, realistically there are other types of assets like real estate and cash but in our case, they are not entirely relevant in their pure form. I am saying pure because realistically you can invest in ETFs which holds shares of real estate companies but in our case, these type of real estate investments are into the ETF section.
To diversify first you have to split your initial investment and decide where you want the most weight. The simplest way is to put more weight in more risky and volatile products such as stocks and to diversify them with exposure in less risky products such as bonds.
Since we spoke for correlations before and we have a separate video on this topic as well I am not going to get into details about it but it is an important part of the diversification.
If you have a portfolio including stocks, bonds, ETFs and commodities you have to have such as positively correlated products and negatively correlated products as well. For example, if you have exposure in financial stocks and financial ETFs these products are positively correlated. So, if you win in one you will win in the other as well and the same goes if you lose. However, in this case, you can diversify these positions with exposure in some bonds which will give you small yield and with exposure in gold because in the perfect scenario it is negatively correlated to the markets because people use it as a safe haven. In this way when one of your positions earn the other will either stay flat or lose a bit and it the end you will realize profits.
You may ask yourself – well yeah but what’s the point to lose we can have exposure only into the profitable positions. Well…theoretically this is correct but if something unexpected happens on the markets like crash caused by news or events your losing positions will become winners very quickly and if you are quick enough you will save some of the profit of the other positions or at least close them on break-even. This is how the diversification works and, on many occasions, it will save your account from burning and leave you in the game.