As you know, there are different strategies for portfolio formation in each market and country. Even in a certain market, the investment strategy is not the same over time and this strategy will change over time. But what all the world’s top investors agree on is reducing investment risk by diversifying investments or building a portfolio. In this article, we are going to explain the common ways of portfolio diversification.
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Strategies for forming a low-risk and diverse portfolio
Succeeding in the stock market of companies, like any other market, requires choosing the right approach and maintaining order. Without these, investing will be just unplanned sales that make the investor’s profit or loss more dependent on luck than on skills such as research perseverance, analytical power, decision-making ability, and patience to achieve goals. And things like that.
Among the various approaches to investing in the stock market, diversified portfolio formation is recognized as a passive but relatively reliable method. Using this method reduces the amount of risk and keeps the return on investment at a level close to the return on the total market. But a diverse portfolio can become a framework for testing an individual’s ability to manage assets, in which case it will become a perfect example of active management.
The present article first explains the principle of diversification and the mechanism of building and managing a diverse portfolio . Here are some ways in which a shareholder can use their analytical and managerial skills in a diverse portfolio and, in addition to reducing the level of risk, focus on gaining more returns from the market.
Diversification, a shortcut to reduce risk
” Diversification ” is one of the most common methods for reducing unsystematic risk. Unsystematic risk arises from the effects of events that are related to the nature of a company or a particular group of companies. Usually such events do not affect the whole company or the whole market. For example, a government decision may increase the costs of a particular industry and thus reduce the stock prices of companies in that industry, or a company’s poor management of market development may weaken its position vis-رق-vis competitors, making it more profitable than others. Reduce and this will lead to a drop in the share price of that company. But each of these events directly affects the stock returns of related companies, not the market as a whole. Segment diversification can reduce unsystematic risk by building a portfolio of shares of different companies .
In contrast to unsystematic risk, there is systematic risk. Systematic risk refers to the effects of a set of general events on the returns of a wide range of companies and industries that are not easily predictable or controllable. For example, fiscal and monetary policies of governments, the overall performance of the economy, political conflicts, natural disasters, and the constant changes in market psychological conditions or so-called “market atmosphere” are examples of these events, each of which can positively return the entire market or Negatively affect. Systematic risk cannot be reduced by diversification. This risk is related to the time when the investor enters a market with the aim of making a profit and accepts it. For this reason, systematic risk is also called “market risk”.
What are some ways to diversify your portfolio?
In theory, the greater the number of shares in a portfolio and the less or even negative the dependence of the returns on each portfolio, the less unsystematic the risk. But diversification in practice comes with challenges such as “cost”. Even if an investor can buy the shares of all listed companies, in practice the transaction costs or commissions are so high that the benefits of diversification are meaningless. In addition, managing a large portfolio of stocks requires considerable time and facilities. Issues such as determining the dependence of share returns on each other are still a challenge, even in theory.
Despite all these challenges and based on experimental results, the use of diversification to reduce non-systematic risk seems possible. In financial sources, it is often said that a small number of shares – for example, more than 10 shares – can significantly reduce unsystematic risk. There are several approaches to building a diverse portfolio, including a market based on market value and a weighted portfolio .
Portfolio based on market value
In this portfolio, the weight of each company’s stock in the portfolio is determined according to the market value of that company compared to other portfolio shares. For example, if 10 shares with the highest market value are selected and the market value of the first share is 15% higher than the second share, the weight of the first share in the basket should be 15% more than the weight of the second share. The market value of the company is equal to the total number of shares of the company multiplied by the price of that share. The weight of each share in the basket is determined according to the ratio of the purchase value of that share to the total value of the basket.
For example, suppose one million tomans is allocated to buy ten shares to form a basket. In this case, if 1000 shares of a company are purchased at a price of 200 Tomans, the purchase value of that share is 200,000 Tomans and the weight of that share in the basket is equal to 20% (200,000 Tomans divided by one million Tomans). In order for this portfolio to be based on market weight, the ratio of the weight of the shares in the portfolio must correspond to the ratio of the market value of the companies related to each share in the portfolio.
Basket of equal weight
The structure of this basket is simple. Because the weight of all the shares in the portfolio are equal regardless of the market value of the respective companies. For example, in the same basket of one million tomans, 100 thousand tomans must be allocated for the purchase of each of the ten shares. The shares themselves can be selected from among the largest companies based on market value.
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