Diversification or financial asset allocation is a great risk management technique, a way to prevent a major loss and mitigate the risk of exposure, regardless of the size of the portfolio. In addition, it is important to take into account that this diversification be not only within one particular type of investment, but considering factors such as its class and maturity, e.g.: Bonds, Stocks, Commodities, Real Estate, Art, etc.
Depending on the size of capital handled and the experience as an investor, the risk tolerance can be higher or lower. Likewise, the likelihood of losing the capital is definitively lower with a diverse portfolio and we need to understand that risk cannot be eliminated. At least not entirely.
Now, some of our clients ask if the risk tolerance of an individual is the same, regardless of the role he or she plays on the investment spectrum. This marks a very important point in the investment approach.
One easy assumption is that an independent investor can probably act a bit more aggressively, given the high experience and risk tolerance, as opposed to an individual who represents a company as an external consultant or its CFO for instance, in which case the reality may shift. As a company representative, the individual has the obligation to be prudent and careful with the investments that he or she places on behalf of the firm.
This presumption is only valid if you assume that being a dedicated partner or consultant provides the same level of trust of a CFO. Which technically is not entirely true, because the CFO needs to considerate the incorporated voice of a board, whereas a consultant is a professional devoted solely to give unbiased advice to a firm, or an individual client.
At Estrategia Financiera y Tributaria, we offer our clients the upmost professional support and trust companion. We provide you with the resources to help you decide what we judge to be the most optimal valuation assessment. We work with you and accompany your firm on valuation comparison, mergers and portfolio diversification decisions.
As David Hillier illustrates on the textbook about diversification, the major benefit of it is that increasing the number of securities in a portfolio reduces the overall risk of the portfolio. However, diversification will not reduce the risk to zero, only down to a certain amount. Mathematically, the risk only goes as low as the covariance level, which still does carry an inherent level of risk. (Hillier, 2013).
How do you think strategies such as a diverse portfolio can well benefit an entrepreneur with capital venture funds, as well as a wealthy experienced investor? Would there be a difference in the game plan for both players? Please stay tuned and I will be happy to cover this and other questions on upcoming blog entries.
Orlando Gómez – Master in Finance
References:
Hillier, D., Ross, S., Westerfield, R., Jaffe, J. & Jordan, B. (2013) Corporate Finance, 2nd European ed. New York: McGraw-Hill/Irwin.