Risk diversification: the main rule of successful investments 

Investing means constantly facing various risks. Investors in their work must accept that it is normal to lose part of their investments periodically. It is the reality: who does not risk, he does not earn! However, this does not mean one should put up with losses because it can manage investment risks well.

One of the best ways to reduce investment losses is to build an investor’s portfolio based on proper investment diversification. It would help if you always remembered the words: “don’t put all your eggs in one basket”; therefore, distribute your money between various financial instruments: shares of companies from different sectors of the economy, bonds, currencies, metals, etc. Diversification of investment risks is the most critical lesson in any investment training course, so we will try to explain all the main nuances in an accessible and straightforward way.

What is diversification in simple words?

Imagine that you are the manager of an investment fund and are responsible to your clients for the result. It is highly undesirable to lose money – damaging your reputation and leaving you to competitors.

Investors have entrusted the fund with a large sum of money, and the choice is yet to be made on where to invest it. For example, let’s say you analyzed the situation on the stock market and selected ten promising stocks, while you have statistics that, on average, the chances of growth are 7 out of 10, that is, 70%.

Now let’s compare two possible scenarios

• you invest in only one company;
• You invest in ten companies at once.

In the first case, the chances of making money are 70%, and it is still necessary to guess which stock will rise. And how many in the second? Since statistically, more often 6-8 stores will be in plus and 4-2 will be in the red, the probability of earning will be much higher than 70% – “by eye” about 90%. So it turns out that investing in ten at once is more reliable! Therefore, you will choose this option as a fund manager responsible for investors’ money.

Further, there will be practical calculations, but for starters, the main thing is to understand the essence: investment portfolio diversification can significantly reduce the risk of losing money in investing, increasing the likelihood of earning. So let’s summarize in simple words:

Investment risk diversification is the distribution of the entire investment amount among several instruments to reduce the overall risk of the investment portfolio.

As in the proverb – we lay out the eggs (money) in different baskets (investment options). When investment diversification is used, in the event of an unfortunate set of circumstances, only part of the money is lost, and not all savings at once. In fairness, the proverb must be continued – “Do not put all your eggs in one basket and store the baskets in different places.” After all, if they are in one place with fire, you will still lose everything.

Well, you can still somehow protect yourself from a fire, for example, by diversifying where you store baskets. But what happens if the eggs are not simple but golden?

If the basket falls, the golden eggs will not break. And on the other hand, you obviously will not be happy with the sharp drop in prices for the precious metal. In simple words, portfolio diversification will not save you from this. Such risk is called market or systematic:

Systematic (market) risk is a risk characteristic of the entire market, such as inflationary, macroeconomic, or political.

Diversification of investment risks cannot affect systematic risk. However, each investment instrument has individual (non-systemic, non-market) risks. And here, the effect of diversification will work on them.

To streamline the previous theoretical text for understanding, let’s pay attention to a simple scheme for diversifying an investment portfolio – the more an investor uses a variety of securities, the lower the risk becomes in the form of a standard deviation indicator. Of course, it cannot remove market risk, so it remains with any portfolio size, but diversifiable trouble begins to fall rapidly with each added security. And the larger the number of protection, the smoother this fall becomes, which to a certain extent indicates that the diversification of investments has its limits – it cannot reduce losses to zero.

It obtained scientific confirmation of the practicality of diversifying investment risks back in the 1950s: it was then that the Nobel laureate 1990 Harry Markowitz developed the foundations of modern portfolio theory. Moreover, it was mathematically confirmed that, at the level of intuition, investors already knew that it was necessary to collect an investment portfolio; this is better than investing all the money in a single instrument.

Those interested in the theory’s details can read more about them on Wikipedia. First, however, we must talk about the basic mathematics of diversification right now.

Benefits of Risk Diversification with Examples

Let’s use a real example to see how diversification affects the risks of an investment portfolio. To begin with, we took the history of the stock prices of the ten most prominent companies in the world. Then, we calculated the returns and risks for each of them individually and as part of the overall portfolio:

Company	Yield per year, %	RMS,%	Drawdown, %	Yield / Drawdown
Amazon	13.05	2.21	-34.01	0.38
Microsoft	28.80	1.62	-18.58	1.55
Alphabet (Google)	6.60	1.68	-23.40	0.28
Apple	-4.75	1.93	-38.73	-0.12
Berkshire Hathaway	5.94	1.23	-15.79	0.38
Facebook	-2.52	2.34	-42.96	-0.06
Alibaba	-21.72	2.22	-38.06	-0.57
Jonson&Jonson	16.29	1.16	-16.91	0.96
JP Morgan Chase	3.57	1.26	-22.33	0.16
VISA	25.41	1.47	– 19. 27	1.32
Average	7.07 %	1.71	-27.0 1	0.26
Portfolio 10 shares	7.07%	1.30	-21.78	0.32

You can view and check the article’s calculations if you wish.

So, 7 out of 10 companies could earn in 12 months, most of which are Microsoft and VISA. At the beginning of the article, we assumed, for example, the figure about 70% of profitable shares, but as you can see, it turned out to be entirely consistent with the truth.

Let’s explain the indicators in the table:

• profitability for the year – in fact, by how much the shares of companies have grown in 12 months. The results are very different: from 28% for Microsoft to -22% for Alibaba group;
• RMS (standard deviation) – is an indicator of the strength of the spread of daily returns. The smaller this spread, the lower the investment risks. We see that diversification had a significant impact on the portfolio’s TSE – 1.30% versus 1.73% (average for all stocks separately);
• maximum drawdown – the most significant drop in prices from top to bottom following it is the most critical possible loss for the investor. A portfolio drawdown of 21% is slightly less than the average drawdown of 27% for each stock;
• yield/drawdown shows the process’s profit and possible losses ratio. The higher this figure, the better. Within the portfolio, the indicator increased from 0.26 to 0.32.

Mathematics confirms that portfolio diversification reduces investment risks. It is enjoyable that drawdowns are decreasing because no one likes to lose money. However, sure you might have thought: “In the portfolio, we received a modest return of 7%, and compared to 25% + from Microsoft and VISA, this looks somehow weak. Maybe it was worth investing in these two companies?

For starters, you need to have the gift of foresight to use such a successful investment strategy. But still, it is a fact that the resulting gain is not very large – the profitability/drawdown indicator increased by only 0.06. And this is provided that three companies out of 10 have reached a value of 1 or higher. Moreover, the fact is that the portfolio we have compiled is not very good in terms of investment diversification. Some stocks are strongly interconnected, for example, the same Microsoft and VISA.

What happens if you add two such stocks to one portfolio? They will duplicate each other and occupy a share of 2/10=20% in the case of our portfolio of 10 companies. Such a megastock’s impact on portfolio risk would be extremely high, causing drawdowns to increase and diversification to deteriorate. Now two stocks rose by 25%; next time, they may fall and significantly increase the overall drawdown of the portfolio.

Portfolio diversification by industry is one of the basic principles of investing in stocks. If you invest all your money in, say, the oil industry, a fall in the price of black gold will lead to a fall in the shares of ALL companies.

To search for relationships between stocks, it is convenient to use the calculation of correlation coefficients in Excel. After studying the strength of the association for each pair of supplies, we got the results in the form of a table. It turned out that Microsoft and VISA are far from isolated cases in our portfolio:

Remember that the closer the correlation value is to one, the stronger the relationship. As you can see, not only Microsoft and VISA but also Alphabet, Apple and Amazon have strong interconnections. It is understandable – the fields of activity of companies intersect in many areas: IT technologies, artificial intelligence, mobile devices, etc.

As you can see, it is not so easy to collect a high-quality investment portfolio of stocks: you need to diversify the portfolio in different sectors of the economy so that there are fewer interconnections. However, the most prominent businesses operate within a globalized world market framework, and systemic risks substantially impact them. Suffice it to recall the global crisis of 2008, when the US stock market fell by 50%, and all sectors of the economy were affected to a greater or lesser extent.

In other words, limiting yourself to investing in stocks is not necessary. You can read more about the various investment options in the article (“Why investments are needed and how they work: a beginner’s guide”). Still, if we want to build a portfolio with minimal correlations, it is worth taking a closer look at PAMM accounts.

Just look at the strength of the diversification effect in a portfolio of 10 PAMM accounts:

PAMM account	Yield per year, %	RMS, %	Drawdown, %	Yield/drawdown
Sphere	4.13	1.51	-22.44	0.18
AO-hedge	24.77	1.72	-18.85	1.31
Opera	74.92	2.06	-11.76	6.37
Keltner channel pamm	40.11	1.90	-21.97	1.83
Hola EUR	-12.22	1.06	-22.47	-0.54
Gamemaster	53.27	2.04	-22.07	2.41
Profiting	-17.47	1.57	-31.88	-0.55
Celtic	-10.11	1.37	-25.73	-0.39
Frame	54.96	2.19	-23.47	2.34
Solar	-11.81	1.93	-31.79	-0.37
Average	May 20	1.73	-23.24	0.86
10 PAMM accounts	May 20	0.52	-6.09	3.29

The MSD decreased three times to 0.5%, drawdown – 4 times to -6%, and the profitability ratio to drawdown reached 3.29, that is, more than 3.5 times! The risk scores of the PAMM accounts on the list are not that much different from stocks, but diversification worked much better. It achieved it primarily because we selected PAMMs without strong correlations among themselves:

Correlation calculation allows you to find non-obvious relationships between assets quickly, and this technique is definitely worth using if you want to build a high-quality investment portfolio. But, what other nuances and tricks do you need to know to diversify your investments properly? More on this!

Rules for competent investment diversification

Many novice investors think it is enough to break their capital into several parts to protect their portfolio from losses. They believe that the risks will decrease on their own – but this is naive diversification and often does not work well, as we have already seen in the portfolio of the ten largest companies.

When compiling an investment portfolio, first of all, you need to understand what risks diversification of investments should protect you from. To do this, at least, it is worth knowing what risks exist in general and then trying to reduce them. For example, if we return to PAMM accounts again, we need to take into account the following ones:

• trading – possible losses from unsuccessful trading by a PAMM manager on the foreign exchange market;
• non-trading – the probability that the broker will “ suck off ” and not return the money;
• inflationary – losses due to high inflation of the currency in which you invest;
• currency – losses due to unfavourable changes in the exchange rate of the investment.

Recall that PAMM accounts are a mechanism by which several investors’ investment accounts are connected to the manager’s account, creating a single trading account for transactions in the Forex financial market in the interests of both parties. A PAMM account can be considered as one of the trust management options. The investor does not manage his money but trusts an experienced manager to do it. To give money to a bank for management, you need to have solid capital, and you can open a PAMM account even with $1 in your pocket.

In PAMM accounts (and any other exchange-traded instruments), the trading risk is most often encountered because transactions do not always end successfully. So, an investor needs to diversify risks from trading losses, which is enough to invest in several PAMM accounts (do not forget to check them for correlation). Further, you can reduce non-trading risks – we invest through 2 or 3 brokers for a safety net. Finally, it can reduce inflationary and currency risk according to the principle of “two birds with one stone” – investing money simultaneously in dollars/euros and the national currency.

Another rule of good diversification: use different investment vehicles. Investing in equities alone will reduce some systematic portfolio risks it cannot eliminate.

– An analysis of the growth ratio of the S & P index against gold shows that gold begins to grow in price actively during and after crises in the US stock market. And vice versa – for example, since 2013, gold has been at the same level, and the index is constantly conquering new peaks. It is not an accident but a normal economic process: gold is considered a reliable asset during crises, and investors massively transfer their capital to it when the stock market falls.

Finally, it is worth mentioning one more rule of qualitative diversification:

Rebalancing – adjusting the shares of assets to return to the original percentage composition of the portfolio.

To avoid going far, we again use the stock + gold example. Let’s say we invested in these assets 50% to 50%. In the first year, shares rose, and gold fell in price, a new distribution of shares in the portfolio – 60% to 40%. The rebalancing is that we sell part of the shares and buy more gold to return to the 50/50 scheme.

What have we done? Followed the oldest principle of trade – “buy low, sell high“! The share price rose, and we sold some of them reasonably. At the expense of the received profit, we bought additional cheap gold. It works.

Over 25 years of reinvesting profits, a portfolio with rebalancing can win over 100% of the return, and this is a lot. With its help, we earn more while complying with the diversification requirements.

So, the four basic rules of quality diversification:

• do not just “spread money into baskets”, but reduce specific risks (trading, currency, inflation, etc.);
• check assets for correlation and interconnection to improve diversification;
• use different investment instruments, especially those that have a reverse economic relationship (for example, stocks and gold);
• use rebalancing to increase portfolio returns.

Next, let’s look at another exciting topic.

The limit of the effectiveness of investment diversification

Every investor, sooner or later, has a question – how many assets should be in the portfolio for diversification? Maybe just 5 or 10 is enough? Or do you need to strain and collect an extensive portfolio? And this would not be desirable because there are many problems and difficulties:

• the more assets, the more difficult it is to keep track of them;
• an extensive portfolio requires a lot of money;
• will have to spend a lot of time on the analysis and accounting of investments;
• the number of quality assets is often limited.

And yet, does it make sense to collect an extensive portfolio? As always, we will answer this question with the help of calculations. For example, we decided to take the well-known Dow Jones stock index, which contains shares of various sectors of the American economy. It includes 30 companies, which is just enough to test the diversification of both small and large portfolios.

To solve the problem, we chose random portfolios of 1,2,3…30 stocks and, by enumeration, were looking for the range in which the risk value of the portfolio falls from the above quantitative range of supplies. First of all, we considered the standard deviation, which shows the magnitude of the spread in returns (the more significant the space, the riskier the investment method is assumed).

The result showed that with an increase in the number of shares from 1 to 4, the RMS quickly drops from 1.4% to 1% and even lower. Further, the value of 0.9% is reached relatively quickly on a portfolio size of 7, but it was impossible to reach the next target of 0.8%. Progress almost completely stops at 15-20 stocks. Dozens of companies need to be added to further noticeably reduce risk, which may require too much analytical work from the investor. Investing directly in the index is better, but that’s another story.

A similar picture is obtained for drawdowns: the maximum drawdown of portfolios starts to decrease sharply when moving from 1 to 5 shares and reaches -22%. Further, it is possible to win another 2% only by 14, and it cannot even win the next 2%  by 30. The best result is about 20 shares.

Simply put, from the considered diversification calculations, we can draw the following conclusions:

• the minimum portfolio size for a noticeable reduction in risks due to diversification is 4-5 assets;
• an acceptable limit of diversification efficiency is reached at 15-20 assets.

From a mathematical point of view, there is most likely no specific limit to the diversification of investment risks since a slight step-by-step decrease in risks still occurs even after 20 stocks in the portfolio.

However, how practical it is to invest in dozens, hundreds of assets simultaneously – probably, each investor must decide for himself.

It could be the end, but in the future, I would like to share with you one more exciting thought.

Two more mandatory types of diversification

In general, we have already talked a lot about the diversification of investments. But, still, in general, this is only part of a great principle that you should use as much as possible in your own, and not only investment, life. After all, our risks do not end with the loss of deposits.

The first type of diversification to use is income source diversification. Today, you won’t surprise anyone with such a story: they were fired from work, they can’t find a new one, there are no cash receipts, and they have to borrow from friends and look for improvements to exist somehow. So, of course, first of all, for such situations, there should be a reserve fund, which guru investors talk about. But it’s even better to have some source of income in reserve that will help you survive a difficult life period.

We consider various options for passive income as one of the best options for such diversification. Most of them do not require a considerable investment of time, but they can bring money for years. And in general, it is nice to receive income, regardless of whether you work today or not. In addition, passive income allows you to get closer to the financial independence many dreams of.

The second type of mandatory program is the diversification of savings. Again, we separate the concepts of “savings” and “investments” because first, you cannot afford to lose: no savings – no secure financial position.

On the other hand, investing is risky; you need to be ready to lose some money. But what if the investments are lost, and there is no monetary safety net in reserve?

In our opinion, savings should be divided into three parts:

1. National currency;
2. Dollars and Euros;
3. Bank deposit.

Savings in the national currency are good because they are always at hand when needed. Of course, they may suffer from inflation, so transferring most of the savings into safer dollars or euros is better. If desired, they can permanently change, but as savings, they protect well from a depreciation of the national currency. And, finally, to earn some money, you can and should put part of the money into a bank deposit. Under this scheme, your savings will be diversified and protected from possible risks, and it will not require much time from you. In case of force majeure, at least part of the money will remain safe and available. In general, diversification is a valuable life principle.

DISCUSSION: COMMENTS, OPINIONS

–  Opinion. Very relevant information in the conditions of wild inflation. I am currently considering diversifying assets to preserve their value in first place. Well, some part goes to medium-risk and high-risk projects. So tell me, is it worth considering multicurrency deposits to protect the value of monetary assets?

Comment. You need to keep money in different currencies. But multicurrency deposits are not an option because bank deposits barely beat inflation. If your priority is the safety of money, then you can try. But still, you can find more interesting options, for example, precious metals retain their value well despite any economic crises, and they also allow you to earn an average of several per cent per annum.

–  Opinion. Before that, I considered the portfolio division only as an opportunity to reduce the risks of investing. But now I realize that diversification also protects against a completely unprofitable investment. Moreover, it allows you to pull income to some average, realistic indicator. If you want to participate in an HYIP project and the opportunity not to risk all the “eggs” at once. Is it possible to ensure the complete safety of investments?

Comment. Diversification averages investment returns to reasonable, predictable limits, making them more stable and consistent. Therefore, the best investment funds make a profit year after year only through diversification.

–  Opinion. “Is it possible to ensure the complete safety of investments?” – after all, you can put money in a Swiss bank. And so, some risks are always present, and as an option, you can insure against them, but not the fact that it will be profitable. Reducing risk to zero usually means zero or negative returns, as returns and risks are inextricably linked.

Comment. In almost any life situation, diversification allows you to reduce the risks somewhat. And investing is always a significant risk. And here, diversification is indispensable. But this also does not give a full guarantee of the safety and multiplication of invested funds.

–  Opinion. What other ways are there to minimize the risks associated with investments?

Comment. First, an intelligent and balanced choice of investment instruments – not based on “what you liked”- after a detailed analysis and comparison with analogues. The risks are automatically reduced if the portfolio has the highest quality and most promising assets. It includes training in investing – this will give knowledge about the choice of quality assets. It is also worth correctly distributing the shares of support in the portfolio, and there are different methods: equal shares, risk pyramid, drawdown optimization or standard deviation. You can also use insurance and hedging.

–  Opinion. Are there any critical relationships between the stock prices of companies of various specializations that should be considered when diversifying your investments? For example, suppose the share price of fuel companies begins to fall. In that case, the shares of which industries will grow this case – manufacturing, computer technology, or the extraction of precious metals?

Comment. These relationships are strong between companies in the same sector of the economy. For example, shares of oil-producing companies are linked to claims of oil and gas and oil processing companies, as well as the exchange price of oil. Therefore, it should study links between companies from different industries.

–  Opinion. Forming a portfolio of assets is an essential thing in investing. But from the university program, I remember the Markowitz portfolio. This model allows you to create an optimal investment portfolio with minimal risk. But is this applied in practice?

Comment. The Markowitz model looks nice in theory, but its effectiveness is debatable in practice, primarily because it creates an optimal portfolio based on historical data. As you know, past performance does not guarantee future performance. Another drawback of the Markowitz theory is the lack of tools for determining entry and exit points; there is no understanding of when to take profits and exclude assets falling in price. And yet, according to Markowitz or another optimization technique, the optimal mathematical portfolio will allow you to get the best profitability and risk ratio if the market is calm and predictable.

Thinking about risks in Crypto. Unknown   

The concept of known and perceived

CONSCIOUS KNOWLEDGE	UNCONSCIOUS KNOWLEDGE
I KNOW	I KNOW WHAT I DON’T KNOW
I DON’T KNOW, BUT SOMEONE KNOWS	WHAT HAPPENED NOW?!
CONSCIOUS NON-KNOWLEDGE	UNCONSCIOUS IGNORANCE

All the events of June this year made us rethink the topic of risks again and dust off Nassim’s Taleb books “Antifragility” and “Black Swan”.

Almost everyone suffered in connection with the departure from the crypto market of such giants as Terra, Celsius or 3AC portfolio companies. Each of these projects has affected the price of every cryptocurrency, even the safest of them: BTC and ETH.   

We want to introduce you to a concept called “famous, famous” by Donald Rumsfeld. It is a way of classifying different risks.

1. Known, known

These are the risks that you know about and can prepare for.

• You know you can be hacked, so you protect your funds with a hardware wallet;
• You know that DeFi platforms can be hacked. You check to see if the auditors have confirmed the security of the protocol;
• Autocompounders are often hacked. Therefore, the return may not be worth the additional risk.

These errors are the most preventable.

2. Known, unknown

You know that there is a risk, but you are not sure of its consequences.

• Protocol has an anonymous founder. You’re not sure if he values privacy or hides a dark past;
• You invest your bitcoins in centralized finance ( Ceci ) to generate income, but you do not know HOW they generate this income.

3. Unknown, known

The risks are KNOWN for some, but they are UNKNOWN for you.

• This includes recent events with the attack on Terra Luna and Anchor protocol. Some insiders knew that Terra was a pyramid. Several people called Terra Luna Ponzi project. They knew, but most didn’t know (or didn’t want to believe it);
• After this cycle, we will all be warier of charismatic cult leaders. And the next generation? They will believe the deception and invest in anyone who hangs noodles on their ears. But, unfortunately, there is a Mavrodi for every age.

4. Unknown, unknown

It is the most difficult and falls under the category of a black swan.

• These are situations that we can NOT predict or plan for.
• What happened to Three Arrows Capitals (3AC) Fund  falls under this. Nobody foresaw this. There was not a single reveal trend warning us of the potential insolvency of 3AC.

Conclusions

Classify your risks using this structure. The first two categories are “easy-hanging fruits” and point to many avoidable mistakes. It’s like playing chess. Stop making mistakes with your queen.

Don’t underestimate the influence of the unknown, the unknown. You can be 100% in BTC and not risk anything else, but recent events can still significantly impact prices.

Attention! These types of events will happen again.

Never underestimate human greed. A new generation of investors will not understand what happened to 3AC, Celsius or Terra.

And yet – Diversify!

We love Crypto, but we think putting all your eggs in one basket – investing in one sector- is idiotic. Hedge against this with real estate, cash, stocks, other assets, etc.

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