Investment 101: How to create a diversified portfolio
How does diversification work, and what does it look like in practice? For anyone new to investing in loans, or simply looking to brush up on their investment knowledge, this guide breaks down the basics.
What is diversification?
If you’ve ever heard the phrase, “it’s easier to hit a sitting duck than a moving target”, you’ll know that the same thinking can be applied to your investments. Diversification is an investment strategy that helps investors reduce their overall risk of getting ‘hit’ by a bad investment by spreading their money around.
Since all investments come with the risk of losing the money you invested, diversification is a way of reducing your exposure to the risk associated with one particular investment, by spreading your capital across multiple investments. This means holding several investments over different assets, geographies, currencies, maturities and other differentiating factors.
The purpose of diversification is to make sure that no single part of your portfolio carries the entire burden of a ‘win-or-lose’ situation in the event of one or more investments failing. The more varied your portfolio is, the less you’ll feel the impact of circumstantial events on the individual parts when you look at the portfolio as a whole.
Why it’s important
Perhaps you’re thinking, “So why not just make the right investments every time?” Even for the most experienced investors, loss of some sort — such as a company going bankrupt, or an unexpected market dip — is considered par for the course. It’s the nature of investment; you can only speculate, then hope for the best. To quote billionaire investment tycoon, Warren Buffet:
“Diversification is protection against ignorance.”
In other words: none of us have the ability to see into the future and know the upcoming value of our investments for certain, therefore diversification is your safety-net against the unforeseen.
By the very nature of investment, correlation means that some asset classes will move in accordance with– or in opposition to — other investment classes. If we look at ‘traditional’ assets, stocks and bonds perform differently under market pressure. When the economy is doing well, the value of stocks may rise, with a clear opportunity for profit. At this time, bonds aren’t necessarily the first investment choice because their returns don’t take advantage of the increase in market value. But if the stock market were to suddenly crash, investor demand for the low-risk bonds would increase, since they would receive fixed payments of a pre-specified amount that a volatile market might not be able to guarantee. Alternative investment assets such as loans can further diversify traditional portfolios, for even more buffering against the unexpected.
On Mintos, you can make the argument for the importance of diversification within the same asset class. In very simplistic terms; let’s say you hold part of your investments with European lending companies, and the other half with lenders in countries outside of this region, in Russia, Kazakhstan and Indonesia. If an economic disaster happens in the EU which negatively impacts the value of the euro and businesses within this area, your non-European investments would be less likely to suffer as negatively. Even if your European investments were to fail, your portfolio could still make profit overall as long as the others investments were successful.
Diversification on Mintos
There’s no single proven way to build a diversified portfolio, but whenever we’re asked what diversification looks like on the Mintos platform, it goes something along these lines:
- Having at least 100 different loan parts
- Investing a minimum of €500
- No more than 50% of your portfolio made up of 5 (or less) lending companies
- No more than 20% of your portfolio made up of loans issued by one lending company
- No more than 50% of your portfolio made up of the top 3 countries where loans are issued from
- No more than 33% of loans issued from any one country
- No more than 50% of your portfolio is made up of any one loan type (e.g. car loans, personal loans, etc.)
These recommendations focus on the importance of a wide range of factors in your portfolio for maximum diversification. Mintos offers many different lending companies, different loan types, loans with and without buyback guarantees, secured and unsecured loans, and different maturities, geographies and currencies.
Mintos offers different investment strategies for different preferences. If you find the choices too overwhelming to build a portfolio manually, there’s even a feature to create automated investment strategies that take care of the decision-making for you. The diversification algorithm automatically selects a diverse portfolio of loan parts in just a few clicks of a button.
If you prefer to invest manually, here’s some of the main aspects of diversification to consider…
Lending companies
Perhaps the biggest risk of loan investment is the risk that the lending company issuing the loan defaults, which is why it’s so important to hold loan parts with a range of different lenders. Our Mintos Ratings guide ranks each lending company (known on our site as ‘loan originator’) with a score ranging from “A+” to “D” to help investors build a diverse portfolio of different risk types.
However, it’s worth noting that simply putting all your money into an “A-rated” lending company won’t guarantee success. Likewise, a company rated “C” wasn’t always given a lower rating as an indicator of it having financial issues. In both cases, there could be other factors at play to explain a change in rating, like local licensing or legal issues, so your best bet is to diversify as much as possible.
Loan types
Lending companies on Mintos offer a number of different loan types, including personal loans, and loans for mortgages, business, invoice financing, pawn-broking, car and short term loans. On the Mintos statistics page, you can see a breakdown of loan types by lending company in relation to their typical past performance. Here, diversification is recommended to protect you from any unexpected changes that occur within the industry or environment of each loan type.
Maturities
In the world of investment, diversifying across different maturity options can be one way to help weather the storm of specific global events, such as recession. For those prepared to wait it out for several years, longer-term investments can offer benefits such as steadier returns in the long-run. Another advantage of investing in loans with different maturities is that you can enjoy a regular stream of returns, rather than a single endpoint when all your investments conclude at the same time.
Geographies
The COVID-19 outbreak, the financial crash of 2008 and Brexit are all examples from recent years to show why investing across different geographies (the countries where loans are issued) matters so much. By spreading your investments out across the world, your portfolio is best protected against unexpected global events. As well as this, investing across different geographies can also work to your advantage if one region is doing particularly well economically, such as a small country with an “up-and-coming” economic power.
Interested in diversifying your portfolio?
No one knows what the future holds for their portfolio when they set out to invest, but diversification can help you avoid putting all your eggs in one basket. Create a free account on Mintos and start investing from as little as €10.
