What is financial risk diversification?
SAVINGS AND INVESTMENT I July 31, 2020
Financial risk diversification is one of the basic principles that should be taken into account when investing our money. According to this idea, owning different types of financial assets mitigates the risk of investing in only one type. In other words, it is understood that risks can be mitigated if we spread our money across products with different risk and return expectations.
And how do we diversify the risks of our investment? We can do this in different ways. We can diversify, among other ways, by assets, by sectors, by time horizon, by currencies, by geographical areas or through investment funds.
Diversification by asset. It consists of maintaining a combination of the main asset classes (equity, fixed income and money and equivalents) in our portfolio. E.g.: if we have 10,000 euros saved up and we want to invest it, we should not put it all in the same basket, i.e. buy only shares in one company. If we did this we would be risking our entire investment on the future of a single company.
Diversification by sector. It implies acquiring assets from companies in various sectors (energy, real estate, technology, banking, basic goods, etc.), since depending on the economic cycle, some sectors will behave better than others. Or, at certain times, a decision by the economic authorities can have an impact on a particular sector, and compromise our investment if we had only invested in that sector. Having assets from different sectors of activity could compensate for these fluctuations.
Diversification by time horizon. It is based on combining short, medium and long term investments and also on entering the market (investing) at different time points, instead of investing all our capital at once.
Diversification by currency. It is a strategy that consists of mitigating investment risks by acquiring shares or other assets in different currencies (euros, dollars, pounds, yen, etc.) so as not to expose our capital to the fluctuations of a single currency.
Diversification by geographical areas. It consists in investing in companies from various countries, in particular those offering legal security. A new example to explain this way of diversifying: if we only had shares in Spanish companies, a drop in the country's economic growth forecasts could damage our portfolio.
In all the above cases, what we are doing to diversify is to make investments that are affected by different factors, or that are affected differently by the same factor.
Correlation is a statistical measurement that measures the relationship between two variables. In the world of financial markets, these two variables can be any two assets: shares, bonds, stock indexes, funds, etc. If these assets are correlated, it means that their returns move in the same direction (if one asset rises in the stock market the other one does too; if it falls, the other one behaves the same way). Conversely, if two assets are negatively correlated (decorrelated) it means that their returns move in opposite directions: when one goes up in the stock market the other goes down.
An example of decorrelated assets is the dollar and gold: when the US currency rises, the price of gold falls, and conversely, when the dollar falls, the price of gold rises. Another case of negatively correlated assets are fixed income and variable income products. On the Internet there are tools to calculate the correlation coefficient between two assets.
Therefore, when configuring a diversified investment portfolio it is important to take into account asset de-correlation, that is, to incorporate products that behave differently in view of the markets. It is true that we will never get the maximum return this way, because not all our assets will appreciate at the same time, but what we will achieve if we follow this strategy is to reduce the volatility of our portfolio and the risks of the investment we have made. In fact, it may be that those assets that do not perform very well in a phase of stock market rises are the ones that end up protecting our capital in times of corrections or uncertainties in the stock markets. However, if all our assets were correlated in a positive way, we might do very well at a certain point in time and have higher gains, but if the situation were to turn negative, all our assets would fall together and we would have significant losses in our portfolio.
In short, knowing that in an investment the risk can never be completely eliminated, it is advisable to follow some basic recommendations:
If you are thinking of diversifying, at Banco Santander you will find information on investment funds, portfolio management or investing in the stock market. Remember that financial instruments are products that can depend on fluctuations in market prices and other variables. Depending on the type of financial instrument, its value may go up or down, so recovery of the invested capital may not be assured. Past performance is not a reliable indicator of future results.
It is also important to bear in mind that financial instruments involve certain risks (market, credit, liquidity, currency, interest rate, etc.), all of which are detailed in the product's legal documentation. The nature and scope of the risks will depend on the type of financial instrument and its individual characteristics. Before investing, the investor should read the information contained in the legal documentation of the financial instrument.
This information is provided for informational purposes only. Its content does not constitute the basis of any contract or commitment, nor should it be considered as an investment recommendation or advice of any kind.
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