The BEST Guide on Diversification: Investing Tips 4 Dummies

Here's the 7 pages guide on diversification you never knew you wanted.

If you consider yourself an investor, you must know all about diversification and how important that is.

Getting exposure to different variables is vital in any investment strategy, but it’s much more than just getting exposure to different asset classes, as you’ll see by reading this article.

I feel that this platform gives people the means to become investors themselves, yet provides very little education for people to actively keep and grow their money earned.

Considering that, I made this ULTIMATE guide on diversification, telling you all about it, some techniques in order to pull it off successfully, and some mistakes even pros make sometimes.

Granted, even though I’m a profitable investor, I’m a new one and so I run into these pitfalls heads first some times, I’m not afraid to say – but don’t do what I do, do what I tell you.

 

Introduction: What Is Diversification?

“Don’t put all of your eggs into the same basket”.

Diversification reduces your overall risk by increasing your exposure to different industries, assets, instruments, strategies, and so on.

It will, if things are done right, maximize your profits by giving you assets that react differently to the same event – therefore negating some of the losses negative events may cause on some of your assets.

Just because one of your investments is very profitable (say, like a DeFi project or Yield Farm), it doesn’t mean you should allocate all your funds to it – that is dangerous and irresponsible.

The cream of the crop of investment professionals states that diversification is a long-term strategy as it allows to minimize risk. However, they add the strategy can be tricky and expensive, and bring with it lower rewards – but that’s the price to pay for minimizing risk.

Again, the Risk-Rewards rule is golden.

 

Understand Fundamentals: Diversification and its Fundamental Rules and Basis

COVID-19 is a prime example of how a situation can hit many different markets.

If you were investing heavily in tourism-related stocks, you are now having a bad time for sure.

However, if you were deeply invested in tech stocks, maybe your portfolio boomed.

Diversification means that the gains you got from the industries boosted by COVID-19 offset the losses you experienced in industries that were damaged by it.

This way, you minimize your value drop… or you can even make a positive increase if the profitability of the tech investments surpasses the losses of the tourism representation in your portfolio.

But how would you get to the conclusion that tech stocks were the thing to buy to prevent your tourism stocks to drag you down with them?

• When you buy an asset, you must think about the underlying business model and its flaws.

• Then, you need to search for assets in which their business models profit from the events that may trigger the flaws of the previous asset.

But why stop there?

You can then think about the flaws of the second asset, and get an asset that prevents you from losing too much if they get trigger…

…maybe even getting a third asset that prepares for negative events of the second while being protected by its own negative events by the 1st.

It is all about insight, economic knowledge, and practice.

This way, if any of the baskets fall, you’ll still have eggs for your omelet!

This is why I have:

- DeFi Assets

- Crypto Wallets with POS Tokens

- Crypto Wallets with POW Tokens

- Transactional Tokens (LTC, BCH, DOGE)

- Ecosystem Tokens (EOS, ETH, STEEM, TRON)

- Stocks

- ETFs

If I was aiming for profitability alone, I would probably be all in with DeFi – but I chose to minimize my risk in exchange for a bit more tranquility.

The market swings often for one of these assets, but I don’t worry too much as I have got exposure to markets that often swing the other way…

…that, and the fact that I take losses as a great way to accumulate more assets.

Losses are great to get in…

Finally, one last thing you have to know, is that location isn’t as important as it once was.

When reading investing literature, you often read about geographical diversification and how vital it is.

Well, due to the way the system works now, and globalization, this variable is losing importance with each passing day.

I’d say looking into “political conglomerates” is much more important now.

The way different states cooperate or antagonize each other has a lot more economic impact than the zone they are in.

 

What % Should I Have on Each Asset: Diversifying Rules

This is where it gets tricky as each person has his own rules due to the fact they apply their own strategies.

My best advice is that you formulate your own strategy, or research what the average number is on the assets you’re investing in.

Always remember that whatever is that you find, you should always take it with a grain and salt and adapt everything to your own preferences and strategies.

 

Understanding Systematic Risk: Why Crypto Can Change It

One of the core concepts of diversification is that you can only mitigate assystematic risks and that systematic risks, that is, the kind of risk that affects all companies can never be mitigated.

This is where Crypto is going to change the game as far as investments are concerned.

Normally, systematic risks have to do with:

• Central Banks Interest Rates

• Political Problems and Measures

• Inflation

…among others.

This comes from the fact that traditional economies and centralized companies operate on the same system – crypto will change that.

In a sense, Cryptocurrency is the ultimate asset to mitigate systematic risks, and probably one of the only ones who ever existed since they are majorly decentralized and therefore immune to Central Bank shenanigans and Statism-backed inflation.

In the past, systemic risks had to be accepted…

…but now you can actually diversify in order to mitigate these as well!

 

Some Literature-Based Problems with Diversification:

There are some known downsides for people who diversify their investments, and professionals know this.

In fact, some investors have really imbalanced portfolios, but it works for them as they have managed to evade risk by being smart, lucky or both.

Some literature-based problems with diversification are:

• It’s cumbersome to have a diverse assets list, and managing it properly.

• It’s expensive

• It caps your profits lower than if you’d stick with the most profitable assets in your portfolio

Finally, let me just stress out that despite what I’m saying above, diversifying is really the smartest choice, but you should never get complacent or think that by diversifying you’re immune to risks as it’s important to never get too comfortable on an asset – no matter how protected you think you are.

Not only that, if you purely think of assets and asset classes while diversifying… you may be INCREASING your risk, and my next paragraph is all about that.

 

Don’t Diversify by Assets: Diversify by Strategies

You may notice that the literature on investing and diversifying talks a lot about diversifying by assets… so it’s only natural that we see so many newbies basing their diversification strategies around this.

Well, I’m going to tell you what I believe to be a better alternative since assets say little about the underlying mechanisms of macro-economy and micro-economical processes.

While this may sound complicated at first, it really isn’t, so let me make this as simple as I can.

There is a concept that runs parallel to diversification which is called “Return Driver” or “Driver of Returns”.

This concept represents the driving factor of the strategy behind the assets you buy.

If you only think about assets and asset classes, you may inadvertently build a diverse portfolio with something in common – the Driver of Returns element.

As your driver of returns is common between all of your diversified holdings, one simple event that botches that driver of returns is going to completely wipe you out, no many how many assets or asset classes you exposed yourself to.

 

How to Diversify by the “Driver of Returns” Rule:

Now we’re really talking… now we’re doing the right stuff by diversifying by “Drivers of Return” and investment strategies, leaving that diversifying by asset classes nonsense behind.

Well, first of all, what is your core investment?

What’re the “Drivers of Return” of that investment?

What is the condition table your assets rule themselves by and what can undermine their performance?

This is the real question…

If you’re serious about investing, you don’t think so much about an asset, but about its underlying drivers and how to capture the maximum amount of returns from the said driver.

Having said that, there is a recurrent formula in investment literature people seem to follow to describe a sound investment strategy, I’m sharing it below:

Investment Strategy = Market + Driver of Returns

The market value represents the system, economy, crow, segment, etc… while the driver of returns represents the mechanism by which the asset rules itself by, and its base.

If you fail to consider one of these variables, your investment strategy isn’t sound.

If you don’t understand one of these variables – you cannot diversify.

Understand your assets first… THEN diversify.

For instance, if you really like to hold long on equities markets, then you’re probably fond of the driver of returns of the equities classes in general.

Think about what are the variables that may undermine such driver and plan accordingly.

 

Enter the DrawDowns Pit: Another Variable is Added into the Diversification Cocktail

So, now that you’re comfortable with the variables I wrote about up until this point, it’s time to add yet another variable into the mix.

First of all, let me assure you that no investor learned about all of these variables simultaneously – we learn them as we go, and that’s how we evolve.

This may seem too much, but what usually happens is that the investor learns each variable through practice, experience and losses along the way… climbing each concept as it if was a step towards his overall profitability.

Drawdowns can be called the “risk gaugers” as MDD or Maximum Drawdowns can really be the key in gauging risk.

This could be a whole article altogether, but since I don’t want you to flood on information, I’ll leave this concept here so you can dive into the drawdowns pit at your leisure and learn as you go… for now, I prefer to write my last paragraph on something you should definitely start considering starting now.

 

Analyzing Volatility and its Connection to Sharpe Ratio:

Volatility is sometimes used to measure risk – although this isn’t the right thing to do as volatility fails to accommodate for the “Driver of Returns” variable.

Regardless, it can help to consider it because of its correlation with something known as Sharpe Ratio, which is a measurement ratio used to evaluate portfolios.

When volatility decreases, the Sharpe ratio increases, and when volatility increases, the Sharpe ratio does the opposite.

This correlation between these two variables can help you combine risky positions in a safer way.

Sharpe ratio accommodates for metrics to measure the relationship between your investment portfolio risk and the risk-adjusted returns.

Using all of this, you can get a better grasp on how two assets move against each other and are able to spot if the returns of said assets or securities are negatively correlated.

What does a negative correlation mean?

It means that when one of those is getting losses, the other is probably getting good returns.

By diversifying in this way, you reduce overall portfolio and investment volatility because all of your income streams compensate each other’s volatility and you get kind of safeguarded from each individual stream’s volatility movements.

By doing this, your Sharpe Ration will increase.

You need to always think about combining different “Driver of Returns” assets and strategies that have a negative correlation.

If you can’t find a good negative correlation to diversify in, diversify to non-correlated assets.

Never diversity to assets with positive correlation!

In Conclusion: Investments Are Not a Sprint, But a Marathon

If you think that by becoming an investor, you’re going to place buys and sells and get rich overnight… you’re thinking about it wrong.

Investing is all about the long run, and this is why minimizing risks is so important.

Not only that, you need to study a lot in order to stay profitable, since you need to understand pretty hard to grasp concepts and learn a lot of what influences both micro and macro economies alike.

In fact, one of the reasons that led me to post about this today is that by writing it, I’m forcing myself to remember all of these concepts and I’m learning them once again and making sure they are fresh in my memory.

You see, I want to be a millionaire…

I know that is hard, and that it requires hard work… I’m willing to put that work in.

In the end, only those willing to study, work, and most of all THINK are going to make it – we can’t all be rich… but damn me if I’m not going to be one of the few who does it.

Cheers!

A-Coin, @CryptoBabe , Scott Cunningham- Thank you!