What is diversification and how does it work?

Our previous article on economic indicators was interesting to readers, so we decided to continue the topic of traditional economy. In this paper we will briefly address diversification. This method can be used in the crypto market as well, because there are a lot of coins that belong to different crypto directions (NFT, DeFi and others).

Diversification is the allocation of investment assets to secure their deposit by investing in different financial instruments that are either non-existent or poorly interconnected.

Now, in simple words. Through diversification, the investor tries to secure its funds from different market situations. This is done by investing all the invested money in different types of assets, such as gold, Sberbank, Bitcoin and Gazprom shares. So if Bitcoin has a subsidy, it’s only a quarter of our investment, so the rest of us don’t suffer. The logical question is: if gold and Bitcoin are clear, then what about the shares of Sberbank and Gazprom, is it the same type of asset? Yes, it is: both are securities. The difference, however, is that the two companies belong to different sectors of the economy – finance and oil and gas. The probability that the subsidy will contain both sectors at once is very low. If you invest in shares of Apple and Microsoft, it will not be a diversification, because both companies belong to the high-tech sector, in other words, when one stock subsides, the second will also sink.

The essence of diversification

For the term «diversification» very suitable old Russian proverb: do not put all eggs in one basket. It does not accurately reflect the essence of the method described. In normal life, the example of diversification is rather problematic: as it happens that investment practice is not too common in Russia, so there are few examples. But one can still refer, in a sense, to diversification.

As it happens, most wealthy Russians like to invest in real estate or gold. Although the topic of investment is far from old for Russians, they do realize that it would be far safer to invest somewhere than to keep. Why do Russians choose real estate and gold? Whatever the political or economic situation in the country, real estate will always be valued, and if it is not a house to be demolished, it will not go anywhere. Gold is considered the most stable asset, or a protective asset: it has minimal volatility and is always valued. In other words, if all the currencies of the world cease to have any value, then gold will have weight in the calculation: it will be able to make an exchange.

The most famous investor in the world that a good part of humanity has ever heard of is Warren Buffet. He’s 90 years old, and he built his fortune, $70 billion, on investment. His investment portfolio has about 50 different assets that helped him to sustain minimal losses in the spring of 2020. We all remember the beginning of the coronavirus pandemic, with many companies losing money or closing down altogether. Warren’s portfolio included many shares of US airlines, which, like similar companies in other countries, bore the greatest losses on the event as a whole. The fact is that as of May 2019, Warren’s fortune was estimated at $86 billion, but the coronavirus decided to «pluck» part of his savings. In April 2020, Buffett sold all shares of existing airlines, with losses of about $13 billion. But, if the billionaire’s investment had not been properly allocated to different assets, the losses could have been much greater. A clear example of how diversification helps investors to protect themselves from unexpected market situations.

Basic rules

Let us now consider the basic rules to be followed for effective diversification:

  • If your passion is in stocks, besides choosing companies from different sectors, try to find those that compare favourably with others. These can be young companies with good and appropriate products, as well as undervalued ones and those that are currently in subsidy. As an example, in 2008, when the entire US banking system was suffering, Buffett’s shares depreciated significantly in local financial institutions. While everyone was selling, Warren was buying, and by 2010, his investment had paid off in full.
  • If you are not fixated on one type of asset, but are willing to invest in different directions, it will play into your hands. There are many assets in the world: local and foreign currencies, cryptocurrency, stocks, government bonds, precious metals, goods, real estate. It is likely that not all assets are mentioned here, but even these are enough to secure your investment. But do not forget that one type of asset must account for no more than 25% of your funds, otherwise diversification will not be effective, because in case of subsidy the losses will be more significant.

There was a brief discussion on diversification, which is sufficient to understand the substance of the method. There are many strategies and tactics that are available on the web, but in order not to upload you with a stream of unknown information, you can read them yourself if you wish.

We remind you about the RevenueBot service, which provides automatic trading on the crypto market.

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