Greetings, dear investors and traders! The topic of today’s article is a diversification of risks which is done in order to ensure their maximum control and reduction using an investment and asset portfolio. Let’s find out what it is all about and how we can use it.
You will learn:
1. About the essence of the investment portfolio
2. Why the investment portfolio is essential
The investment portfolio is a basket of financial assets. It is also sometimes referred to as «financial portfolio». The whole point of the investment portfolio is to diversify the capital among various assets the investor expects to get a return from, thus reducing the risk for the entire financial portfolio.
The less correlated the assets in the investment portfolio are, the more protected against the risk this portfolio is.
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Examples illustrating formation of investment portfolios
To put things into perspective, let’s consider two scenarios:
- The investor invests all of the capital in one security or currency.
- The investor diversifies the capital between 10 different assets i.e. 1/10 of the total investment capital accounts for each asset.
Now, let's imagine that the asset our investor decides to invest in is a security with TLRD (Tailored Brands) ticker symbol.
The investor sees that the price is maintained at $23 from a technical standpoint, or that this company has fundamental prospects, and so the investor decides to buy the stock in hopes that its price will reach $29.
At first glance, it may seem that everything is going smoothly. There is no deviation from the algorithm. The risk per trade according to Risk Management is 1 %. The investor is very optimistic about the future outcome of the investment.
However, as it often happens in financial and especially stock markets, there comes an unexpected turn of events. The stock opens with a large price gap contrary to our expectations i.e. long position opened by us.
In this scenario, the investor who allocated all of the capital to a single asset realizes that his or her loss totaled 32 %.
The investor will have to start building the investment capital all over again only because he or she did not factor in or simply didn’t use diversification method (distribution of capital among various assets) within the investment portfolio which can reduce investment risks exponentially.
Now let’s get back to the investor who distributed the capital among ten assets in the investment portfolio. The TLRD stock price drop, where the investor expected an increase, eventually resulted in -3.2% loss which is not that dramatic.
The bottom line
Investment (financial) portfolio allows managing the risks much better in case of a sudden change in one of the assets.
It is obviously important to pay attention to the correlation between the assets. The smaller the correlation, the more leveled your risks are within the portfolio.
It should also be noted that the portfolio diversification works not only in terms of stocks. This may very well be a portfolio originating from the real sector: real estate, metals, and antiques, or it can be a portfolio of TIMA managers.
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Essentially, it all boils down to maximum control and reduction of risks for one of the assets.