Investment Diversification: Definition and Tips
Investors know that in order to invest, you always have to take risks. There can be various risks - it is possible to lose part or all of the investments, they may be delayed and not returned in time. Therefore, experienced investors follow several rules and principles that allow them to reduce the risk of their investment portfolio. One such principle is investment diversification.
What is investment diversification?
The essence of this principle is to break up your investments in smaller amounts into larger amounts of different investments. For example, if you can invest a total of 1,000 euros, then following this principle you divide this amount into, let's say, 5 parts and invest 200 euros each in different investment offers. Such a strategy helps you reduce the risk you are exposed to, as it is less likely that all 5 investments will fail or delay the return of the money you have invested. The more divided the investment portfolio is, the more you reduce the risk you take, so you can divide 1000 euros into 10 parts instead of 5, for example, and invest 100 euros each, thus making your investment portfolio even more protected and balanced.
Principles of investment diversification
Diversification is relatively easy to understand and apply if the basic principles are followed:
- The first principle: investing in different asset classes/investments – experienced investors do not only have company shares in their investment portfolio, but also add other securities or alternative investments, such as crowdfunding platforms, to their portfolio. In this way, investors are not dependent on one sector or investment instrument, as a result of which, they manage to balance their portfolio and protect it more.
- The second principle: proportional distribution of investments. You can invest in many things: stocks, bonds, cryptocurrencies, precious metals and crowdfunding and other investment instruments. However, a proportionate investment portfolio should be maintained, in which the riskiness of the instruments and the potential return would be balanced. The portfolio can be guided by the following proportions - 20% of the portfolio can consist of lower risk investments, then 70% of medium risk and only 10% of high risk investments. Of course, each person's risk tolerance is different, and so is our knowledge and experience in the field of investing, so these proportions may change over time. If you have a higher risk tolerance, then the investment portfolio can be made up of slightly riskier investments and vice versa, but in one case or another, it is important to maintain diversification.
- The third principle: diversification according to geography - the investment portfolio will not be fully divided and balanced if we invest only in one country or even a city, because in this case our investment portfolio is fully affected by the local economy and market. If a crisis starts in the country, then your entire investment portfolio would, likely be delayed and we would face troubles, so in this case it is best to distribute your investments among different geographical points - at least several countries, so that investments do not depend on the economy of one country, because it is less likely that 3-4 countries will face a crisis than one. On the Profitus platform, it is possible to invest in projects located in as many as 4 different countries: Lithuania, Latvia, Estonia and Spain, which allows investors to lend their funds not only to Lithuanian, but also to foreign entrepreneurs and thus diversify their investments even more widely.
Diversifying your investment portfolio is now easier than ever. Various investment opportunities are available to everyone - from deposits, shares to peer-to-peer lending and crowdfunding, which used to be the privilege of banks, has now become available to everyone. We will briefly review several types of investments to make it easier to understand the riskiness of investments and how to allocate them in order to have a properly balanced investment portfolio.
Low risk investments
Deposits and government bonds can be classified as low-risk investments. Deposits are classified as low risk, because in Lithuania all deposits up to 100,000 euros are insured, so by keeping your funds in deposits, you do not risk losing them, but the return is correspondingly lower. Currently, you can earn about 4% annual interest by keeping your money on deposit. And government bonds are securities, with the help of which you lend to the state, in exchange for which you get the right to receive the amount corresponding to the nominal value of the debt securities, interest, etc. It is recommended that low-risk investments make up about 20% of total investments, as this ensures that the investment portfolio is well diversified.
Medium risk investments
There are many medium-risk investments, including real estate, stocks, crowdfunding, and even some bonds, although they are usually classified as lower-risk investments. Medium-risk investments are riskier than deposits or government bonds, because investing in them requires more knowledge of the market, understanding of investment principles and interest in order to invest successfully. One of the medium-risk investments is crowdfunding, which gives both individuals and legal entities the opportunity to invest in business loans with real estate collateral. It is like a simplified investment in real estate, because investors lend funds to real estate developers who develop real estate objects and from the sale of the project or rental income returns investment. This kind of investment is becoming especially popular, because by investing in various loans, the investment portfolio can be very widely diversified. For example, on the crowdfunding platform Profitus, more than 40 loans are financed every month, so the distribution of funds can be very wide. It is recommended that the investment portfolio should consist of approximately 70% of medium risk investments, as this will allow proper diversification of investments.
High risk investments
Risk-tolerant investors can discover and test high-risk investments such as crypto-currencies, art, commodities, etc. There are more such niche investments that have a high potential return, but before starting to invest in the riskiest markets, you should assess your risk tolerance very well, because in the media and online space we often hear success stories about how money is made from crypto, NFT, works of art and other risky investments, but painful experiences, losses and losses are usually not reflected in the media or are quickly forgotten, because we always think that "it will definitely not happen to me". Therefore, before starting to invest in this category of investments, it is very important to understand well what we are investing in and what can happen and what we will do if we lose the investment. It is advisable that these investments make up to 10% of your total investments, as this way your investment portfolio will be safer. And later, when you have more experience in the field of investing and properly understand the risks, you can gradually increase this percentage.
Medium risk investments - a rational decision
Moderate risk investments are the golden-mean - you can get a solid return and you won't experience as much risk as investing in high-risk investments. To make the decision easier, several advantages of these investments can be distinguished:
· You will experience risk, but this risk will be easily tolerated enough and you will not have to stay awake at night, fearing that your investment will burn or the situation will change for the worse overnight. For example, in the world of cryptocurrencies, the market situation changes not even in days, but in hours;
· By investing in these investments, you will earn more than keeping money in deposits and thus outpace inflation - when investing in medium-risk investments, the return may vary and it depends on both the instrument and the specific investment;
· Of course, there is a variety of investments even in this category, but in most cases you will need to be less interested and actively manage your investment portfolio than investing in high-risk investments.
Medium-risk investments also include crowdfunding, which has several advantages:
· It is possible to invest in small amounts, from just 100 euros, which allows for a wide diversification of investments, because you do not need a large initial amount and, with just a few hundred euros, you can already distribute your investments to a larger number of projects;
· You can invest in projects located in different countries. For example, on the Profitus platform, you can invest in projects in Estonia, Latvia, Lithuania and Spain;
· When investing through crowdfunding platforms, it is also possible to choose more criteria according to which investments can be divided - it can be risk rating, investment duration and purpose, developer, etc. This allows everyone to create their own investment strategy and, according to it, to diversify their funds into different projects.
For these reasons, we believe that crowdfunding is one of the best ways to ensure that your investment portfolio is both diversified and balanced.
We wish you successful investments and that the investment portfolio not only grows every year, but that new, different types of investments appear in it, which will ensure that your portfolio is diversified and you experience less investment risk.