Who doesn’t enjoy risks? When you are holding your breath and waiting for what will happen in a minute, you feel thrilled. Lots of people believe that investments are the best thing to do to increase adrenaline levels. But it’s wrong. In fact, lacking adrenaline, you should play BlackJack online or go to the amusement park. Investments are not about risks, they are about long-term decisions and rules.
Allocating investments between different types of securities and between stocks of companies from different industries and countries is a way to reduce your risks, which is called diversification. The basic rules of diversification are what every investor should know.
When it comes to building a crisis-resilient investment portfolio, it is advised to spread funds between stocks and bonds. The value of stocks can fall drastically in a short period of time. The price of bonds can also change, but if you hold bonds to maturity, you’ll get back the face value at the end of their life.
The American economist Harry Markowitz was the first to formulate diversification principles for a portfolio of securities in the language of mathematics. His theory allows you to solve two problems: minimize risk at a minimum acceptable level of return and maximize return at a given level of risk.
The advantage of the theory is its simplicity: calculations can be done even in Excel. The portfolio yield is calculated as weighted average yield of its constituent securities taking into account the correlation between the assets. The risk of the portfolio is assessed in the same manner, while the risk of an individual instrument is assessed as the standard deviation of its yield, which is similar in meaning to volatility.
To determine the ratio of securities with different risk levels in your investment portfolio, it is customary to use the following rule. The longer your investment horizon, the higher the level of risk you can afford – there will be time to catch up on losses. Some experts suggest using the following rule as a guideline: the share of bonds should be equal to your age (for example, if you are 30 years old, the share of stocks – 70%, bonds – 30%), and as your age or approaching your investment goal, the share of bonds should increase.
There is no universal rule, much also depends on your goals and risk appetite. If a short-term 20% decline in portfolio value is already a disaster for you, then you need to increase the share of bonds in your portfolio. If you are dissatisfied with low bond yields, but are willing to invest for the long term, you can increase the percentage of your investments in equities.
Seemingly simple: The more securities in your portfolio, the better diversified it is. Back in 1970, researchers calculated that if you have two companies in your portfolio, the specific risk associated with a particular company is reduced by about 40%. If you invest in 8 companies, the non-market risk is reduced by 80%, 16 by 90%, 32 by 95%, and 128 by 99%.
But that doesn’t mean you necessarily need to invest in dozens of companies. Evaluating companies for long-term investments is a time-consuming process. It turns out that if you find 6 suitable companies besides the two companies in your portfolio, you will reduce your risk by 40 percentage points. In reality, you would have to analyze many more companies. But if you add another 8 companies, the risk is reduced by only 10 percentage points. In other words, more effort is needed, but the return in the form of reduced risk will be less.
Also, the more companies in the portfolio, the harder it is to look for new successful investment ideas. For this reason, some prominent investors have advocated having a small number of securities in a portfolio.
Not every portfolio with a large number of stocks from different industries will be reliable. For example, if you buy stocks in retailers, transportation, and telecommunications companies, all of the stocks in your portfolio will be dependent on domestic demand. If people’s incomes fall, the performance of many companies in that sector may deteriorate, and as a consequence, the stock will go down in value.
In order to diversify properly, you will have to understand a little bit about how companies do business and the risks associated with the industries in which they operate. Your job is to assemble stocks that don’t depend on each other or on a single metric.
There are no universal rules, so you’ll have to turn to financial gurus. The optimal portfolio should look like this:
- 30% invested in stocks of large companies.
- 15% – gold and other commodity assets.
- 40% – long-term government bonds
- 15% – medium-term bonds.
Such a portfolio will show returns even during economic downturns and market crises. Gold is a defensive asset. Its price usually rises when everything else falls.
Different term bonds allow you to protect yourself from key rate risks, on which bond yields depend. True, in serious crises the face value of a bond can go down, so it’s better to buy bonds with the same term to maturity as your investment horizon. If you’re investing for 5 years, buy a bond for 5 years, so you’re sure to get the face value. For the same reason, conservative investors should choose bonds with a short term to maturity.
If you invest in corporate bonds, as with stocks, spread your investments across different industries, so you reduce risk.
When markets are calm, stocks rise in value much faster than bonds. So if at the beginning of the year you had, for example, 60% stocks and 40% bonds, by the end of the year the ratio might change: for example, 75% to 25%. In this case, your portfolio will need rebalancing, because such a portfolio will already be much more risky.
There are two ways to do this. You can either buy more bonds to get back the ratio that suits you, or you can sell some stocks. You should do the same if a certain industry’s share has become too large: your portfolio becomes too risky. If your instrument allocation hasn’t changed much, your losses on commissions from buying and selling assets will probably be greater than your potential risk.