Diversification: What it is and its importance

Diversification is one of the simplest yet most useful investment strategies that every investor should utilize. Diversification helps investors minimize risk while ensuring more stable returns. In this article, we will explain in detail what diversification means, what its types are, and provide several practical tips that every investor should consider when diversifying their portfolio.

In this article, you will learn:

• What portfolio diversification is and its importance in investing
• Types of diversification
• 5 tips for portfolio diversification
• Portfolio diversification at Fumbi

What is portfolio diversification and what is its importance in investing?

In simple terms, portfolio diversification is the distribution of investment risk across multiple assets within a portfolio. This approach works on the principle that different assets react differently to changes in economic conditions. While the price of one asset may decrease, another may increase, contributing to more stable returns because one asset effectively offsets the other.

With diversification, you don’t rely solely on a single class of assets, such as stocks, but combine them with other assets, like cryptocurrencies. This strategy helps mitigate risks associated with market fluctuations and provides better protection for your invested funds.

Imagine you have €10,000 and decide to invest everything into the stocks of one company, such as Tesla. If Tesla performs well, you could achieve significant gains by investing all your money into its stocks. However, if an unexpected issue arises, such as a decline in demand for electric vehicles, regulatory interventions, or broader economic problems, Tesla’s stock value could drop significantly, and you might lose a large portion of your investment. By investing everything into one company, you expose yourself to the high risk of that company’s failure.

However, if you spread your money instead of putting it all into Tesla, and allocate it among Tesla, Apple, government bonds, cryptocurrencies, and ETFs, you avoid systematic risks, and your portfolio becomes more resilient to external factors. For example, if Tesla’s stock price drops due to regulations targeting electric vehicles, your portfolio wouldn’t suffer a significant loss and could remain profitable because the other assets would not be affected by those regulations.

Types of diversification

There are several ways to diversify your investment portfolio. In the following paragraphs, we will introduce the types of diversification that can help you build your portfolio.

Diversification by asset class

Investing in different asset classes is one of the most common forms of diversification. It includes investments in various types of assets such as stocks, bonds, cryptocurrencies, real estate, commodities, or cash. Each asset class responds differently to market conditions, which reduces the overall portfolio risk.

• Stocks: While stocks can deliver high returns, they are also associated with higher risk.
  
• Cryptocurrencies: Similar to stocks, they offer higher returns at the cost of higher risk.
  
• Bonds: They provide more stable returns but come with lower risk and lower potential gains.
  
• Commodities: Investments in commodities like gold or oil are often seen as protection against inflation and market instability.
  
• Real Estate: They offer stable long-term returns, often independent of fluctuations in the stock market.
  
• Collectibles: Paintings, collectible coins, jewelry, and similar items can also serve as investments, but they come with entirely different risks, such as vandalism or theft.

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Diversification across sectors

Different industries and sectors vary significantly in how they operate. When investors expand their portfolio across these industries, they reduce the risk of being affected by risks specific to a single sector.

As an investor, you can diversify your investments across various industries by combining investments that can mutually balance the risks of different companies. For example, consider two industries: travel and digital platforms.

Investors aiming to protect themselves from future risks, such as events that keep people at home – like the COVID pandemic – can invest in digital platforms that would benefit from such a scenario. At the same time, they can invest in airlines, which thrive in environments with fewer restrictions. Theoretically, these unrelated industries can balance overall portfolio risk, as both benefit under different conditions.

Diversification by investment style

Diversification can also occur within a single asset. In this case, it focuses on the investor’s approach to investing.

You can diversify a stock portfolio based on growth investing and value investing. Growth stocks are established companies with expected above-average earnings growth and carry lower risk because the company already has some history behind its brand. Value investing involves stocks of lesser-known companies considered undervalued, carrying higher risk because the investment relies on the company’s growth potential without certainty of achieving those gains. Diversifying between these types of stocks allows investors to leverage future growth potential while benefiting from the stability of established companies.

Additionally, as an investor, you can focus on small or large companies. Stocks with lower market capitalization are typically small companies offering greater growth potential, while large-cap companies are generally safer investments.

In the realm of cryptocurrencies, Bitcoin can serve as a safer investment due to its large market capitalization. On the opposite end of the spectrum are riskier crypto assets, such as meme coins (e.g., Dogecoin or Shiba Inu) and DeFi tokens, which, despite their higher risk, offer significantly greater profit potential.

5 tips for portfolio diversification

1. Do not rely on a single asset class

While some assets may deliver higher returns, it is unwise to invest all your funds into one type of asset. Instead, allocate your funds across multiple asset classes, such as stocks, bonds, and cryptocurrencies, to reduce risk and stabilize portfolio performance.

2. Consider geographic diversification

Investing solely in the domestic market can be risky. For example, if the local economy faces challenges, your portfolio could suffer significant losses. Including international investments in your portfolio helps protect you from economic shocks in a single country.

3. Regularly review your portfolio

Market conditions are constantly changing, so it’s important to regularly review your investments. What was profitable five years ago may no longer be optimal today. Regular monitoring and adjustments will help maintain a balance between risk and return.

4. Avoid short-term market trends

Trends come and go, but diversification is a long-term strategy. Resist the temptation to invest all your funds into trendy assets promising quick gains, as they often carry high risk and a potential for collapse.

5. Utilize dollar-cost averaging

By investing smaller amounts regularly over time, you can minimize the risk associated with short-term fluctuations. Averaging your purchase price allows you to invest in assets at different price levels, reducing the impact of market volatility.

Portfolio diversification at Fumbi

We at Fumbi approach diversification responsibly. That’s why we launched our first product, the Fumbi Index Portfolio, which consists of more than 20 cryptocurrencies, reducing risk while increasing the portfolio’s potential return. The weights of individual assets in the portfolio are adjusted daily based on current market developments – the Index mirrors market movements and adjusts its composition accordingly.

The portfolio includes various cryptocurrencies, including more stable and well-known ones such as Bitcoin and Ethereum, as well as growth-oriented and riskier projects in areas like DeFi, AI, NFTs, and other blockchain innovations. This approach allows clients to benefit from different sectors of the cryptocurrency market without the need to manage their investments individually. Fumbi automates and optimizes processes to provide clients with the maximum possible diversification, with a focus on long-term growth.

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We have also considered more conservative investors…

At Fumbi, we understood that some investors are partially open to innovation but still prefer more traditional and stable investment assets. That’s why we created a special index consisting of Bitcoin and Gold, combining the time-proven stability of gold with Bitcoin’s strong technological and growth potential. This product offers an ideal balance between a traditional store of value and a modern approach to money, allowing investors to maintain stability and growth potential within a single portfolio.

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