2/24/2022 - Economy and Finance

How to diversify our portfolio smartly?

By Gustavo Neffa

How to diversify our portfolio smartly?

Small investors do not have the same tools as Bloomberg or Reuters data terminals, nor the time, nor the knowledge as to optimize their portfolios to win to the market. It's not even your goal. On average, retail investors are made up of preserving the purchasing power of the currency they invest in (earning inflation) and gain ideally and at the same time the dollar., at least in Argentina, but it is also applicable to any emerging country or which has greater risk to the average.

You can learn a lot from the big institutional investors: In this note, we will see that the need to diversify an investment portfolio is a lesson that investors never finish learning and applying beyond their known benefits.

How to diversify intelligently?Large investors have high amounts of money that they attribute to many assets, because they have a lot of money under administration. The basic rule consists of not buying more than 2.5% of an action or volatile asset (the percentage is subjective and depends on the size of the fund). A 10% drop in an action would not impact more than 0.25% in the portfolio. Of course, small investors can diversify less and therefore make big mistakes. But it is possible to apply these rules, and even for very small amounts to buy common funds of variable income investment that apply it to the fullest if you do not have time or knowledge to closely monitor investments, two non-smaller aspects that always play against small, unsettling investors who do not live in it.

Given that the volatility of individual financial assets exists and that its concentration can be very harmful to an investment portfolio, We will analyze the concept of diversification in a portfolio, the basic tools to calculate the risk of a portfolio and the way to mitigate its effects.The benefit that provides us in our portfolio does not too focus the needs on few assets is easy to understand, but difficult to apply in practice.

Although the standard deviation, which captures volatility, is one of the most known risk measures, is not the only and is not always the one that best predicts the future risk. But that's what's and what's taken into account. In fact, the overall balance model called Capital Asset Pricing Model (CAPM) does not use standard deviation as a risk measure, but only a part in calculating the risk of an asset in relation to the reference market average, called beta.

In addition to the volatility of an asset, there are many factors that would be very difficult to model in the analysis of an action or a bonus, such as liquidity, credit notation, management, the option of rescuing an issue, the option of transforming it, the risk of seniority or recovery priority in the case of financial insolvency, etc. But it could be assumed that volatility captures all these risks, which make it more volatile an asset. It is like saying that the quotation of an action should reflect all that is good and the bad that happens behind a company (always and when the markets are perfect, when we know perfectly that in practice they are not).

The individual risk of each asset can be eliminated or diversify, is the so-called non-systematic risk.But although there are benefits of diversification, the risk of a portfolio cannot be totally eliminated but minimized, because investors will always be at market risk or not diversifiable, called precisely so because it is impossible not to assume, is the inherent risk of a particular asset class or country. If we buy and sell shares in a developed market, we will certainly take less risk if we do so in Argentine stocks, but we will always have to take on the share risk of the American market, which is higher than that of a bonus of that country.

Calculating the performance of a portfolio is simple. The performance of an asset portfolio (expected or well-designed, depends on the task we are performing) can be calculated as the weighted average of the expected assets of the assets that make up this portfolio. The weighting of each asset is carried out according to its percentage share of each asset within the portfolio.

Instead, calculating the risk of the portfolio is a little more complicated, since it not only influences the weighted average of the deviations of each asset, but also influences the correlation between them, which allows to decrease the total risk of the portfolio, which we will analyze below.

Let's put a simple example: if we have actions from a single company in our portfolio, we will receive 100% of the negative impact of an economic fact that perjudes us, as an oil company with a strong low in the price of the raw material, which is its main source of profitability in mature companies, as suppose it is ours.

But If we decide to diversify intelligently, that is, not buying any more shares of oil companies (which is a way to diversify, but not in a smart way), and we buy shares of companies that could react favorably to that same economic fact,we will receive immediately and in the long term the benefits of diversification. We now decide to incorporate actions from an airline, after studying its fundamentals and choosing the best company according to standardized criteria of profitability analysis, solidity, debt, among other aspects. The airline will benefit at the low price of oil, as one of its derivatives is the input to be able to fly to planes.

We assume that good and bad scenarios occur with the same frequency. The impact of the combined net result of two fully antagonistic companies, such as a ice cream factory and other aphids, makes the gains stabilized in time and volatility reduced.One can have the bad luck of counting on actions of a single company and the adverse scenario: jumpers in summer or ice creams in winter.

An investor who has shares of any of the two companies will have volatile gains. And that is precisely what it is to avoid diversifying: that the gains of the whole become stable and, consequently, their contributions on the market (which should reflect this last).

La variance of the portfolio depends on the variances of each asset, but also depends on the covalence that exists between them, i.e. how they covariate the two assets among themselves: as a general rule, if they impact the same variables will not be an intelligent diversification. To measure how well we are diversified we have to know the correlation coefficient between two assets: the matrix of variances and covariances or the correlation matrix are those that will show the relationships between all assets. The lower the correlation, the better. This index can take values between 1 and 1: if two assets have a correlation equal to 1, they have a perfect correlation, that is, when the price of an asset rises 1%, the other rises 1%. If two assets have a correlation equal to –1, the correlation is perfect but inverse, that is, when an asset rises 1% the other low 1%.

How many assets can you minimize portfolio risk?It depends on the active class and the market we are operating in. It is not the same as 100 companies in the US whose most representative index, the S&P 500, have five times more companies in a very large market, which have the few companies in the S&P Merval index of Argentina that concentrate 80% of the combination of operations and volume operated in value.

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gustavo neffa

Gustavo Neffa

I'm Gustavo Neffa. Director of Economics and Finance at FinGurú. Partner and director of Research for Traders, leading a team of market analysts. I spent the last 24 years in the financial sector in both domestic and foreign entities, having occupied the post of Senior Research Analyst in Macrosecurities of the Banco Macro and the BBVA Banco Francés, as well as economic analysts with the economist in chief of the BBVA Banco Francés. I am also a professor in Corporate Finance, Investment Portfolio Management, Financial Asset Valuation, Valuation of International Investment and Finance Projects in various MBAs and postgraduate courses in Buenos Aires and in the interior of the country and professor of the MBA of the UNLP and the UNNE of Financial Asset Assessment and the postgraduate degree in the UBA Capital Market in agreement with ByMA. Co-director of the UNLP Advanced Finance Programme.

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