DIVERSIFICATION OF INVESTMENT RISKS
Diversification of investment risks is one of the most important aspects of investing.
Investments are always associated with possible risks. An essential task for everyone interested in increasing, not losing assets is reducing these risks.
The meaning of diversification is reflected in the adage, “Don’t put all your eggs in one basket.”
The term itself came to us from ancient Rome. From Latin “diversificatio” — variety: “diversus” — different and “facere” — to do. It turns out diversification of investment risks — this is an investment in different assets.
It is dangerous to invest all funds only in any asset. Even if the asset proves to be super-reliable and profitable, alternative assets are needed. Anything can happen. Therefore, all influential investors use the diversification of investment risks. Moreover, ideally, risk reduction should have a minimal effect on portfolio returns.
TYPES OF DIVERSIFICATION OF INVESTMENT RISKS
Diversification is a method of dealing with risks.
Risks are different, Meaning that the diversification of risks is different. There are several strategies for diversifying investment risks. Let us dwell on the most important of them:
Instrumental diversification
Instrumental diversification is the primary, most common, and simplest form of diversification. Instrumental diversification refers to the distribution of investments between several assets of the same type. For example, investing in several companies’ shares or investing in several cryptocurrencies is a manifestation of instrumental diversification.
Let’s say we have a portfolio of 10 different cryptocurrencies. We invested 100 USD in each one; the total investment was 1000 USD.
At the end of the year, we have the following investment results:
✅ Cryptocurrencies 1–8 brought an average return of 15% of the invested funds:
100 USD x 8 x 0.15 = 120 USD
🔻Cryptocurrencies 9–10 turned out to be unprofitable by 25%:
100 USD x 2 x 0.25 = 50 USD
✅ Return on investment was:
120 USD — 50 USD = 70 USD
Currency diversification
Is it profitable to keep savings in dollars now? No. No currency in the world is immune to a sharp devaluation. Even countries with stable and developed economies are not immune from events that may result in a sharp fall in the national currency exchange rate.
If it is possible to hold assets in different currencies, be sure to use it. Some will fall; others will rise.
Institutional diversification
Institutional diversification is when you distribute funds among different investment companies — for example, opening deposits in different banks.
At the same time, there is a concept of the so-called naive diversification, when several different assets are acquired to share risks without considering what kind of danger insurance is provided. For example, an investor may buy shares of several oil companies. And in the event of a fall in oil prices, all these companies’ claims fall in price. Therefore, in institutional diversification, any factor mustn’t interconnect companies. Indeed, in the event of problems for one of the related companies, the other is likely to have difficulties.
Species diversification
The specific diversification of investment risks means the separation of industries in which investment takes place. Why is it important? Any sector is subject to risks. Whether it’s real estate, oil, cryptocurrencies, gold, and more. Even a highly regulated banking sector carries risks. Yes, every country has support and measures from Central Banks. But even they will be powerless if defaults occur in two or three largest credit institutions. Thus, an example of generic diversification is the simultaneous investment in cryptocurrencies, stocks, real estate, etc.
Praem Capital uses various risk diversification methods to ensure that investors receive maximum returns with minimum risks.
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