The main objective of portfolio diversification is to reduce the risk of cash loss. It is an investment in a variety of assets. At the same time, the purpose of diversification is also such a redistribution of own resources, which will allow to maintain or increase the portfolio profitability. To achieve these tasks, different mechanisms are used. Among the main ones are the use of various types of financial instruments. For example, bonds and stocks. In addition, you can use different tools of the same kind. An example is investing in stocks of several organizations.
Types of risks
In order to carry out effective portfolio diversification, it is necessary to first classify the various risks. As an example, it is proposed to consider the shares of a financial institution. The activities of banks are affected by the risks of several main categories. These include government, economic risks, as well as risks of the industry, segment or individual company. To understand the process of diversifying an investment portfolio, it is better to consider them in more detail.
So, government risks are circumstances that can change the business climate in the country. As a rule, the reason for such changes is the adoption of new laws and other regulatory legal acts, as well as the nationalization of private property. In addition, detrimental influences include revolutions or political upheavals.
Economic risks are associated primarily with the macroeconomic situation. Instability in this area can be caused by financial crises, recession or stagnation. Segment risks include crises on exchanges. The risks of the credit and financial industry include interbank crises. In addition, there is always the possibility of bankruptcy of a particular bank. In this case, we are talking about the risks of an individual organization.
Diversification of risks of different types
Now you can consider in detail the mechanisms to diversify the portfolio depending on the class of existing threats. For example, to distribute government risks, it is advisable to divide own financial resources between several countries at once. This method is used by the largest players in the market. We are talking about international investment funds. Such organizations concentrate significant volumes of savings of individuals and legal entities and have ample opportunities for portfolio diversification.
To redistribute investments and minimize the impact of economic risks, it is advisable to use various investment instruments. For example, stocks and precious metals. During a recession and stagnation in the economy, the money resources of most investors drift into tangible assets. For example, in gold. With a fall in the value of shares, it is likely that prices will remain stable in the precious metals market.
Diversification of exchange risks
An effective mechanism to minimize the risks associated with the situation on the stock exchanges is the so-called beta hedging. It consists in the inclusion in the investment portfolio of such assets, the tendency to change the value of which is opposite to the movement in the market. Also, to diversify the financial portfolio, you can use a mechanism such as the acquisition of different types of assets. For example, stocks and bonds.
Risks in an individual industry or company
To prevent industry risks, they use investing in different sectors of the same type of assets. For example, shares of a financial institution. In this case, it is advisable to invest resources not only in bank securities, but also in other property rights. A good option is a parallel investment in shares of commodity companies. In addition, to further mitigate risks, the portfolio can include securities of several companies operating in the same industry at once.
Naive diversification
One of the most common mistakes of novice investors can be called a move along the path of the so-called naive diversification of the investment portfolio. What it is? It consists in buying shares or bonds of different companies without a preliminary analysis of the threat from which such a safety net is made. An example is the acquisition by an investor of the securities of two or more oil companies. In this case, an attempt is made to protect their investments from falling quotes for black gold, but a significant reduction in its value in world markets will inevitably cause a decrease in the price of the investment portfolio.
In other words, the naive diversification of the investment portfolio is the type that can protect the investor’s assets only in the event of the bankruptcy of an individual enterprise. But it will not protect against changes in the economic situation, which has happened extremely often in recent years. To minimize the risks of subsidence of an entire industry, it is necessary to diversify capital to honey in various sectors of the economy. At the same time, a good way to protect against lower energy costs is to include financial derivatives in the investment portfolio. For example, futures.
Diversification of the loan portfolio
The meaning of this variety lies in its distribution among borrowers, which are characterized by different amounts of capital or form of ownership. In addition, banking institutions, when issuing loans, take into account other conditions for the activities of business entities. For example, the industry and the geographical location of production. In this regard, there are three main types of diversification of the loan portfolio: portfolio, industry and geography.
Portfolio diversification
This type of capital distribution involves the issuance of loans to a wide variety of categories of borrowers. These can be large and medium-sized companies, small businesses, individuals, government agencies or public organizations, households and other entities. For example, loans issued to small businesses tend to have higher returns. At the same time, they are accompanied by significant risks. Small entrepreneurs do not have the opportunity to freely choose a lender. Therefore, banks can enter into transactions with representatives of the small business on their own terms. But loans issued to large companies have lower returns, but the risks here are negligible.
Industry diversification
This type involves the redistribution of capital of a financial institution between borrowers who operate in various sectors of the economy. For effective selection, it is recommended to use statistical studies of specialized companies. A special effect in the industry diversification of the bank's loan portfolio can be achieved by choosing borrowers who carry out their business activities with opposite phases of the business cycle.
In addition, it is advisable to choose areas of the economy in which the overall economic situation does not seriously affect the performance of enterprises in this segment. What does it give? When one industry is in the process of growth, the other may experience recession or stagnation. It is likely that over time they will switch places. In this case, a decrease in revenue from one category of borrowers will be offset by an increase in revenue from another group. In other words, conditions will be created to ensure stabilization of the bank's income, which will significantly reduce the risks.
Geographic diversification
It should be noted right away that this mechanism is often available only to very large credit and financial institutions. They, as a rule, have an extensive network of branches and branches over a large territory. The meaning of this portfolio risk diversification is to issue loans to individuals and organizations located in various regions of the country and even several states. Non-identical economic conditions due to the wide geography of lending will minimize the negative effects of various factors.
In addition, various climatic conditions, political circumstances, the level of development of industry and production in a particular region speak in favor of this type of diversification. It should be noted that small financial institutions can use this method. But mainly only during the creation of the investment portfolio, which makes it possible to reduce the overall riskiness of the bank.