What Is Financial Risk  Diversification?

What Is Financial Risk  Diversification?

Financial Risk  Diversification : The diversification of financial risks is one of the basic principles that should be taken into account when investing our money. In other words,  it is understood that the risks can be mitigated if we distribute our money in products with different expectations of return and risk.

Types Of Diversification

  • Diversify by assets.

It consists of keeping in our portfolio a combination of the main types of assets  (variable income, fixed income, and money and equivalents). An example: if we have 10,000 euros saved and we want to invest them, we should not put them all in the same basket, that is, acquire only shares of a company. Well, in this way we would be risking all our investment in the future of a single company.

  • Diversify by sectors. 

It means acquiring assets from companies in various sectors  (energy, real estate, technology, banking, basic necessities, etc.), since depending on the economic cycle in which we find ourselves, some sectors will perform better than others. Or, at certain times, a decision by the economic authorities can have an impact on a specific sector, and compromise our investment if we had only bet on that sector. By having assets from different sectors of activity, these fluctuations could be offset.

  • Diversification by time horizon.

 It is based on combining short, medium, and long-term investments, and also on entering the market (investing) at different times, instead of investing all our capital at once.

  • Diversify by currencies. 

It is a strategy to mitigate investment risks by acquiring shares or other assets in different currencies  (euros, dollars, pounds, yens, etc.) so as not to expose our assets to the fluctuations of a single currency.

  • Diversify by geographical areas. 

It consists of investing in companies from various countries, particularly those that offer legal certainty. A new example to explain this way of diversifying: if we only had shares of companies, a drop in the country’s economic growth forecasts could damage our portfolio.

In all the above cases, what we are doing when diversifying is making investments that are affected by different factors, or those that are affected differently by the same factor.

Decorrelation: How It Can Help Risk Diversification

Correlation is a measure of statistics that measures the relationship between two variables. In the world of financial markets, these two variables can be any two assets: stocks, bonds, stock indices, funds, etc. If these assets are correlated, it means that their returns move in the same direction (if one asset rises on the stock market, the other also rises; if it falls, the other behaves the same). On the contrary,  if two assets have a negative correlation (they are uncorrelated) it means that their returns move in opposite directions: when one goes up in the stock market the other goes down.

An example of uncorrelated assets is the dollar and gold: when the price of the US currency rises, the price of gold falls, and vice versa, when the dollar falls, the price of gold rises. On the Internet, there are tools that allow calculating the correlation coefficient between two assets.

Therefore, when configuring a diversified investment portfolio, it is important to take into account the decorrelation of assets, that is,  to incorporate products that behave differently in the face of the future of the markets.  It is true that in this way we will never obtain maximum profitability because not all our assets are going to 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 that we have made. In fact, it may be that those assets that in a phase of stock market rise do not have a very positive behavior are the ones that end up. However, if all of our assets were positively correlated, we might do very well at a certain point and make higher profits, but if the situation were negative, all of our assets would fall together and the losses on our portfolio would be significant.

In short, knowing that  in an investment risk can never be completely eliminated, it is advisable to follow some basic recommendations:

  • Be clear about the level of risk that we are capable of assuming.
  • Set financial goals to be achieved, preferably in the medium and long term.
  • Opt for diversification and decorrelation of assets as the best formula to achieve them.

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 may depend on fluctuations in market prices and other variables. Depending on the type of financial instrument, its value can go up as well as down, so the recovery of the capital invested may not be guaranteed.

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