What is portfolio diversification and why is it necessary

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YEREVAN, 4 July. /ARKA/.nbsp; Risk is one of the factors that need to be taken into account at all stages of investment- from planning to performance evaluation. Properly identifying potential threats, maximising protection from them and preparing for possible consequences is an important and challenging task for all market participants. A common approach to the solution is diversification./pp

Portfolio risk is measured not by the volatility of individual assets, but by how their price changes are interrelated. If two instruments, which initially appear to be the safest, start to lose value simultaneously, it will lead to a loss. In turn, the synchronised growth of risky stocks will increase capital./pp

Accordingly, it is necessary to collect assets in such a way that when the price of one instrument falls, the others grow and compensate the losses. This is the essence of diversification./pp

This method makes it possible to reduce losses from systemic risks during crises and almost completely offset specific problems. The former arise regardless of the actions of a particular investor: crises, changes in interest rates, currency depreciation, etc. The latter are the result of ineffective individual and corporate decisions./pp

Specific risks are the result of inefficient individual and corporate decisions. These include, for example, bankruptcy of a company or default on debt obligations./pp

The nature of a particular financial instrument and its behaviour in the market, as well as the investor's approach to portfolio formation determine the type of diversification./pp

Let us highlight the groups according to several criteria./pp img width=669 src=/upload/medialibrary/9bf/9bf5ad6e1c70df9f842bd31aaa9555a2.jpg height=445 title=фридом alt=фридомbr/pp bBy asset class /b/p b /bp

Shares are an asset that brings profit, but is associated with large risks and is subject to high volatility, i.e. price fluctuations. These securities are issued by companies of different sizes: large (capitalisation from 10 billion dollars), medium (from 2 billion to 10 billion dollars), small (from 300 thousand to 2 billion dollars). Well-known and experienced issuers with a large number of clients are generally considered reliable, solvent and suitable for novice depositors./pp

When choosing an asset, an investor can focus on value or growth stocks. The characteristics of the first approach is that you buy securities whose current price is below the market price and does not reflect the company's strong financial performance. Value stocks are issued by stable companies that often provide investors with dividends. Therefore, they are relied upon by those for whom predictable, stable income is important. By investing in such securities, an investor hopes that in the future the market will recognise their true value and the asset will bring profit.br The other strategy is to buy high growth stocks, expecting the trend to continue. These are usually issued by innovative and technological companies. Growth stocks can bring very large profits, but they cost more than the market average and come with risks. Most often, companies focus on their own development and do not pay dividends./pp iBonds are debt /isecurities of companies. They can be long-term (more than 5 years), medium-term (3 to 5 years), short-term (up to a year), ultra-short (up to 3 months). Government, municipal and corporate bonds, as a rule, provide low but stable income, as they are issued by reliable issuers with high ratings./pp iCash is an instrument/i that loses a lot with inflation and does not bring passive income. However, it is effective when the market situation is unstable and all assets fall./pp iAlternative assets are investments/i in luxury goods and art, exchange commodities (energy, textile raw materials, products of agro-industrial and agricultural sector)./pp iA portfolio of one asset class/i. The main principle of this strategy is to collect as many variants of one asset in a portfolio as possible. Usually, this is the way to invest in shares, buying securities of different issuers. The wider the range of selected companies, the more effective diversification is. The best number to reduce non-systemic risks is 20-30 shares. It is important to monitor their balance. If one stock takes too large a share, the risks associated with it will prevail. It is recommended to invest no more than 5% of funds in shares of one company. Investors who are not ready to independently determine and control assets can turn to ETFs. These are exchange-traded funds containing securities of many issuers and selecting a balanced portfolio for investors./pp/pp bInvestments by sector/b/pp

According to the SP index, the 500 largest companies traded on US stock exchanges are divided into 11 sectors. Each sector has its own specific features of appearance on the market, certain phases of growth and decline and reacts in its own way to inflation and key rates of the Central Bank. By buying a share of a fund that tracks the SP 500 index on the exchange, you can invest taking into account the correlation of sectors and reduce the overall volatility of your portfolio.nbsp;/pp/pp bBy country/b/pp

Economies differ in their degree of development and market orientation, while political structure and situation lead to certain risks in each particular case. The investor, taking into account all the indicators, can plan transactions with funds in several countries and diversify the portfolio. For example, recognising that economic growth increases demand for raw materials, you are likely to get a good return by investing in developing economies that are export-oriented. During a recession, however, this move is ineffective. By mitigating risk during each business phase by investing wisely in different markets, you will profit throughout the business cycle./pp

Diversification across countries is related to the allocation of capital across currencies. Here it is important to understand how the processes characteristic of a particular economic system are reflected in the exchange rate of national units. Depending on this, you can, by buying securities of foreign companies, receive and reinvest income in different currencies. Another way of currency diversification is to invest cash in currency units of developed countries: dollars, euros, Swiss francs, yen./pp

Any method of capital allocation aims to reduce risk, and this explains the shortcomings of the mechanism./pp

- Capital will grow slower than if invested in risky assets./pp

- During a market downturn, diversification becomes less effective because the correlation of instruments becomes stronger and this makes one of the principles of portfolio construction worse: when one asset falls, another should rise./pp

- Correlations change over time and there is a tendency to strengthen the interdependence of instruments./pp img width=669 src=/upload/medialibrary/4b1/4b10a12583a9a793b310d036e1595bca.jpg height=445 title=фридом alt=фридомbr/pp/pp bConclusion/b/pp

Goals and risk tolerance are individual for everyone, and when determining a strategy, you make your own decision. In any case, it is difficult to imagine that the main intention of an investor is to lose his own funds, which means that additional mechanisms should be applied. Diversification of different types of risks is your defence, as it:/pp - allows you to eliminate specific risks associated with a particular issuer or country;/pp - reduces portfolio volatility;/pp - helps to build a balanced portfolio;/p - helps to compensate for losses after crisis periods.nbsp;br br iThis article was prepared as part of the joint project Year of Investing in Oneself by ARKA, AMI Novosti-Armenia news agencies and a href=http://ffin.am/en/Freedomnbsp;/a/ia href=http://ffin.am/en//aia href=http://ffin.am/en/Broker Armenia/a/ia href=http://ffin.am/en/./abr