How is an investment portfolio constructed? Part 5

Investment diversification

Having, in the latest articlesIf we try to navigate how investments are conceived, structured and selected, it is an obligatory step to talk about how investments are protected. And, how that process of protection simultaneously influences the very process of selecting investments.

Simply put, an investment is protected by diversifying it. Which is nothing more than the old principle of "don't put all your eggs in one basket". Literally, don't put your money into a single investment. Because, just like the farmer, where one misstep or slip leaves him with no eggs, changes in economic and business conditions can seriously undermine your savings concentrated in a single investment.

The definition of diversification is the practice of spreading your investments so that your exposure to risk is minimal. But diversification is more than dispersing, spreading or spreading your money over multiple investments. The key is that this distribution effectively reduces the overall risk of the investments.

Hence, the first lesson is that you don't invest in one security, you invest in a combination of securities, you invest in a portfolio or the anglicism "portfolio". To invest in a single stock, say an airline, no matter how profitable and safe it looks, is to be fully exposed to the risks inherent in air transportation. A major risk for airlines is fuel costs, which depend on oil prices. High oil prices reduce airline profitability. And if the airline tries to raise prices to neutralize oil increases, it can negatively affect passenger demand.

If, in order to diversify, the investor chooses to invest in a second airline, he is only diversifying the managerial risk, i.e. that the second airline has another strategy or other markets, but you are not eliminating the risks derived from the price of oil. You still have few eggs out of the basket.