Before explaining what diversification is, we must be clear that investments in products with low liquidity or with medium-term timeframes (on average about three years) should not account for more than 15% of the total resources allocated to investment annually. To clarify, you should not allocate more than the amount you allocate annually to your pension fund or alternative investment fund (Private Equity or Venture Capital).
Investing in these types of products is not a short-term plan but neither is it long term. It does not look for gains from the first minute but looks at 3-5 years. That is why yields are usually on average higher than 15% per year with this type of portfolio. Therefore, the first thing to do is to be a relaxed investor, capable of building for the future, and secondly, you need to be meticulous, you have to build a well-diversified portfolio that looks at the bigger picture.
Portfolio diversification is the basic principle of operations in financial markets, based on which risks can be minimised when the overall amount invested is distributed among a series of assets with different characteristics. It is also the simplest and most effective means of avoiding concentration risk in an investment portfolio. Throughout this point we will try to provide a simple explanation of what it is, what its advantages and disadvantages are, as well as looking at the points to consider when diversifying a portfolio.
The concept of diversification is very simple. Diversifying is investing your money/equity in various assets whose profitability is not related. That is, investments should not all be exposed to the same risks because, if they were, we could lose our investments in different companies for one single reason. In other words, as the saying goes: "Don't put all your eggs in one basket.”
The main advantage of diversification is that it reduces risk in our portfolio by reducing the two main risks:
> The inherent company risk
> The risk of the investment
It has two further characteristics that make it an ideal method to reduce risk in our portfolios:
> On the one hand, it is simple, as you only need to buy companies that are not correlated.
> On the other, it is effective as it protects us from unexpected events and our own investment mistakes.
The advantages of diversification are accepted by everyone today and apply equally if we talk about either traditional or alternative sectors.
The main disadvantage to diversification is that it implies reducing the amount to be invested in projects with greater potential to invest in projects with less potential which can reduce our profitability (potential profits are reduced but so are the risks assumed).
In addition, diversification usually has a time cost. We spend more time managing a portfolio of 15 or 20 companies than we do for a portfolio with 2 or 3 companies. When using Fellow Funders as an alternative investment platform, this disadvantage is somewhat alleviated as the projects we publish all meet the same standards (they pass through the same risk filters, feasibility analysis and legal contracts) and have a Score for greater ease when investing.
Despite these two small disadvantages, Fellow Funders is a firm advocate of portfolio diversification, especially when referring to alternative investment portfolios. We advise you, therefore, to be meticulous; if you find a project in which you want to invest, do not do so with all you wish to allocate that year to alternative investments but save part of it for subsequent projects.
As an example, if you are going to allocate 5,000 euros to alternative investments in the next 12 months, invest in 5 projects at 1,000 euros each. As you build your portfolio, you can allow yourself to increase shareholdings in specific projects, but never at the beginning, especially if this investment type is new to you.
We already know what diversification is, and its main advantages and disadvantages. Diversification is the simplest and most effective method to avoid concentration risk in our portfolios and our equity. Of course, you have to be aware that diversification alone is not enough; it must be done well if you do not want to put your assets at risk. Diversification in traditional markets is a little different to alternative investments but based around the same concepts.
How do you diversify an alternative investment portfolio?
1. Different companies/Management team
2. Different Geographic Areas
3. Different Sectors
4. Different Targets/Markets
5. Different Technologies
6. Different Times
Whenever possible, you should choose projects with tax incentives. t is not diversification per se, but it reduces the levels of risk assumed.
At first it may seem a bit complicated, but Fellow Funders will always provide the necessary information so that you easily build your portfolio and you understand each and every one of the risks that each project entails. By always working with standards of quality, security, and transparency, decision making will always be easier for you. Remember, if you have doubts about any project, you have the dealing room where you can talk with promoters and other investors about that project and, if you still have doubts, you can always acquire the objective assessment report that details all the data, risks and concepts.