In a previous article, I wrote about David Swensen’s model. Swensen led Yale University’s investment fund for 36 years, during which Yale’s endowment grew from $1 billion to over $31 billion. His success lay in how he diversified every sector of his portfolio, preparing it for both prosperous years and challenging times.
Diversification is a key concept in the world of investing, especially for beginners. In simple terms, diversification involves spreading your money across different types of investments to reduce risk. Instead of “putting all your eggs in one basket,” the idea is to invest in various assets to protect your portfolio from significant losses if one of them fails.
How Does Diversification Work?
Imagine investing all your money in the stocks of a single company. If that company faces a crisis or its value suddenly drops, you would lose a significant portion of your investment. However, if you spread your money across stocks of multiple companies, bonds, and other assets like real estate or index funds, the impact of a bad investment would be much smaller. Some assets might increase in value while others may decrease, helping to balance out the losses and gains in your portfolio.
Diversification doesn’t just mean holding a wide variety of assets. The goal is to have investments that aren’t closely related, so that when one goes down, another can go up. This approach is known as “negative correlation” and is essential to protecting the overall value of your portfolio.
What Types of Assets Can Be Used?
- Stocks: Represent ownership in a company. While volatile and potentially high-yield, they also come with higher risk.
- Bonds: Loans to governments or companies that generate fixed interest. They tend to be less risky than stocks but offer lower returns.
- Index Funds or Mutual Funds: These funds invest in a basket of assets, allowing you to diversify your portfolio with a single investment. They are ideal for beginners looking for easy, automatic diversification.
- Real Estate: Although it requires more capital, real estate offers additional diversification by being a different asset class than stocks and bonds. Real estate investment can also be done through real estate funds.
- Precious Metals and Cryptocurrencies: These assets can serve as a hedge in times of crisis, though cryptocurrencies are extremely volatile. For inexperienced investors, it’s best to use them in small amounts within a diversified portfolio.
Why is Diversification Important?
One of the main benefits of diversification is that it helps reduce specific risk. This type of risk is inherent to a single company or sector. By spreading your investment across different assets, you reduce the impact that poor performance in one company or sector can have on your overall portfolio.
Diversification is also crucial for capitalizing on various growth opportunities. For example, while one sector like technology may be booming, other sectors like real estate or bonds might not be experiencing the same growth. Having exposure to different sectors allows you to benefit from opportunities without relying on just one.
Final Thoughts
Diversification is essential for any investor, but especially for those who are just starting out and lack prior experience in financial markets. A diversified portfolio not only reduces risk but also helps you build a more stable long-term investment strategy. For those just beginning, tools like index funds or bonds are an excellent way to diversify easily and safely.
When it comes to cryptocurrencies, I believe they should be included in any investment portfolio. However, it’s important to carefully manage the percentage allocated to this technology and the projects selected. A percentage around 5% of the total investment is a reasonable figure, though it could be higher or lower depending on your risk tolerance. The choice of projects should be carefully studied by each investor, as it’s essential to be responsible and realistic with this new but risky investment.
Remember that diversification doesn’t completely eliminate risk, but it’s an effective way to manage it. As you gain experience, you can adjust and customize your portfolio to better align with your goals and risk tolerance.