How to properly create diversified investment portfolios, manage them and use investment tools
opportunities?
The investment world is a balance of risk, painstaking analysis of investment projects, and their profitability. Vasyl Matiy, CEO and co-founder of Smart Family Office, tells in a column for AIN how to properly create diversified investment portfolios, manage them, and take advantage of investment opportunities.
Investment portfolio and principles of its formation
There are three types of investment portfolios: conservative, balanced, and aggressive. However, some investors additionally distinguish moderately aggressive and moderately conservative types.
They differ in asset characteristics, risk levels, and instruments. But, in addition, each type of portfolio must evenly distribute all risk categories to compensate for losses, that is, be diversified.
What should novice investors do?
First, analyze each asset for profitability, risk, and liquidity.
The main idea of diversification is that different assets react to market events in their own way, and the negative dynamics of two assets can be offset by the positive dynamics of the other two. This is called negative asset correlation, which results in the investor receiving:
- portfolio profitability optimization;
- reduced volatility;
- compensation of costs from some assets at the expense of others.
The return of a portfolio is equal to the sum of the returns generated by the individual financial instruments included in it. However, high returns do not always mean successful investment, because it is not only important how much you earn, but also how easily you can access these funds.
This is where liquidity comes in—a measure of how quickly and without loss an asset can be converted into cash or another asset. In addition, each asset in a portfolio has its own chance of failure, and usually the higher the potential return, the greater the risk of loss.
The highest returns and highest risk are inherent in the venture type of investment, which I will explain further below.
Benefits of a diversified investment portfolio
To clearly understand why and how to create a diversified investment portfolio, it is worth considering different asset classes and understanding how negative correlation works.
The main asset classes are real estate, securities, and, conditionally, business.
- Real estate has a huge number of subclasses: residential, commercial, land, and data centers.
- In turn, securities are divided into two main classes: shares - that is, corporate rights of public companies, where one share is one measurable unit of the company's capital, which allows the investor to receive profit and have the right to vote. The second type of asset in this class - bonds (government and corporate) - debt securities with a clearly defined face value, a clearly defined yield and a fixed maturity.
- The third asset class is investments in companies that are not yet public and are at that evolutionary stage, such as startups that do not yet have the opportunity or generally do not have the goal of entering the stock market and raising capital there. In my opinion, there is no general clear correlation between all these assets.
American economist Harry Markowitz wrote an article in the mid-20th century called “Portfolio Selection” and described his views on the risks, returns, and interdependence of investment instruments. This material became the basis for the creation of modern portfolio theory, and Markowitz himself received the Nobel Prize for it in 1990.
The main idea of his approach is that it is advisable to consider risks relative to the portfolio as a whole, and not relative to a single asset. Such interdependence of investments is otherwise called correlation. Suppose the price dynamics of two assets coincide at each time interval. Then the value of their correlation is equal to unity. This is a perfect positive correlation.
Let's imagine that in each time period the price dynamics are directly opposite. Then the correlation value of such assets will be equal to "-1". This is a perfect negative correlation. Two investors can have any correlation from "-1" to "+1" in relation to each other.
Let's move on. The same factors can have a positive impact on some assets and a negative impact on others. When some negative phenomena occur on the market, all asset classes fall in price at once. After all, during a recession, people's purchasing power decreases and, as a result, business valuations fall. Accordingly, asset prices also fall.
But, for example, if we compare asset classes of securities, we can see that the correlation between stocks and bonds is often negative and related to economic cycles, crises, and central bank policies.
If a crisis or recession occurs, an effective way to combat it is to lower the key rate, which affects the value of money in the financial system and, accordingly, the cost of loans. And it turns out that when a recession begins, businesses lose customers, reduce staff, and receive lower profits. And, as a result, their stock prices also decrease.
At the same time, to support the economy, central banks are lowering rates — and the lower interest rates are, the more bonds that were issued in previous periods when interest rates were higher rise in price.
Therefore, it turns out that when an investor has a balanced portfolio, his stocks fall in price, while bonds, on the contrary, rise. And this is the negative correlation that smart investors chase so that their investment portfolio does not become a house of cards and does not fall apart immediately when the first fluctuations appear in the market or in the economy.
About the features of venture investing
Venture capital is a type of investment that involves investing in young companies that are in the startup or early stages of their development. It is one of the riskiest, but also highly profitable types of investment.
When a novice investor starts investing in venture capital, especially in the early stages of the startup life cycle, he also needs to wisely shape his portfolio. If before the war in Ukraine, the national idea among investors was “investing in a one-room apartment in Kyiv near the metro,” now the market situation contributes to the popularization of venture capital investments in technology companies.
Swiss investment bank UBS in its annual Global family Office Report indicates:
- 26% of their respondents (317 wealthy families with an average net worth of $2.7 billion) have invested in developed market stocks (4% in emerging markets) and plan to increase this share to 29% next year;
- 18% of respondents are in bonds (15% in developed markets now, with the prospect of growth to 17%), as margin finally covers risks;
- 21% — in private equity (11% — is direct investment, 10% — through funds);
- 4% — in private debt, which is twice as much as last year, and the number of supporters of this investment direction continues to grow;
- 11% — in real estate, slowly reducing this share due to the rising cost of financing and competition from bonds;
- 8% — in cash as a permanent airbag.
New investors also need to understand the types of stages at which they can invest in startups.
There are Pre-seed and Seed stages, as well as Series A, B, C, and D, and the period before the company goes public. Pre-seed and Seed rounds to the conditional first million in revenue are called 3F at the event — Friends, Family, and Fools — a method of raising funding for a startup through a close circle of founders.
It is important to note that it is in the early stages that the largest number of companies go bankrupt. Only 41% of SaaS companies reach 1.4% of 1 million in revenue, and only 0.4% reach 1.4% of 10 million, as found out at Nektar.ai. Others disappear into the so-called “valley of death” — a place where startup ambitions and budgets collapse.
I do not recommend that novice investors build their portfolio from investments in companies that are in the very early stages, because they greatly increase the time to exit (IPO) and have a low probability of making a profit.
A venture capitalist's portfolio should contain at least ten companies, because some of these companies will go bankrupt, some will have mediocre results, and, most likely, only a few companies will be the most successful and provide the target return for the entire portfolio.
Follow Western practice and, with a moderate risk profile, invest up to a quarter of your capital in venture deals and, to form a diversified portfolio of ten deals, invest no more than 1.5–2% in one deal.
Key insights
- Start building your investment portfolio with a small number of assets and gradually expand it.
- Follow the principles of diversification and avoid emotional decisions, even during periods of market volatility.
- Successful investing is a marathon where the winners are not the fastest, but the most persistent and consistent.