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How to design an Investment portfolio: enhancing your strategy with diversification through EUAs

Carbon Markets: Finance

What is diversification in investing? A guide explaining why diversifying your investement portfolio is important and how this can be done through carbon market allowances (EUAs).

How to design an Investment portfolio: enhancing your strategy with diversification through EUAs
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Why do we need investment diversification strategies? Do not put all your eggs in one basket. In other words, avoid aggregating all your investments in one place. When making investment decisions, it is crucial not to rely on chance only, as they say on Wall Street, “a trader never hopes, a trader is never sorry”. One should be smart about spreading their assets to ensure protection against potential losses because of broader economic trends or financial markets moves. Financial portfolio management is key—split your investments across different assets and industries to mitigate risks. 

It is already difficult enough to build a coherent and solid financial portfolio with proven positive environmental impact. It is even harder to make sure that it is well hedged against (or protected from) detrimental macro moves - is a green climate investing diversified portfolio a mission impossible? It is not - European Union Allowances (EUAs) are a great investment diversification financial asset. This is one of the many EUA investment benefits. In an exclusive interview with Homaio (soon to be published!), a professional climate investor and ESG finance expert advocates for allocating 5% of your portfolio to diversification assets such as EUAs, providing a means for investors to make a positive environmental impact, while still following the crucial investment diversification rules.

  • Understanding Diversification in Investing
  • How can one diversify their investment portfolio? 
  • Why are carbon markets and EU emissions allowances (EUAs) good for investment diversification?

Understanding Diversification in Investing

What is the definition of diversification in investing?

Diversification in investing is the strategy of spreading investments across different asset classes, industries, or geographic regions to minimize risk. The aim is to reduce the impact of any single investment's performance on the overall portfolio. By diversifying, investors seek to achieve a balance between risk and potential return, so as to enhance the stability and resilience of their investment portfolios.

Why is diversification in investment needed?

Many assets are highly correlated to one another - at the beginning of the COVID 19 period, all financial markets experienced considerable losses at the same time. They were responding to macroeconomic exogenous shocks that could not be expected by any investor. And they were responding in a very similar fashion, precisely because of the abovementioned correlation. The S&P 500 index lost 32% in just 35 days, and the Nasdaq 100 index experienced a loss of 27% over the same period.

What is the purpose of diversification in investing?

By spreading investments across different assets, investors aim to ensure that a downturn in one area doesn't wipe out their entire portfolio. A portfolio, composed 100% by one of the indices above would be very painful to look at in March 2020 - it would not be easy to lose ⅓ of one’s wealth in just a month for anyone. Ultimately, the goal is to maintain financial returns regardless of market conditions, fostering confidence in the resilience of the investment strategy.

What are the risks associated with a lack of diversification in investing?

A non-diversified portfolio not only exposes investors to the risk of being overly dependent on specific market directions but also can face increased volatility. If there are significant market swings within a short period of time, the whole portfolio would fluctuate massively overnight. So, this could force investors to make speculative decisions about whether to buy or sell based on their beliefs about the permanence of those swings. And this task is best managed by highly skilled finance professionals - this is why a diversification in investment is so important, particularly for non-professionals who do not want to bear such decisions on their shoulders. In an ideal world, a well-diversified portfolio works for its holder on its own.

How can one diversify their investment portfolio?

What are some strategies for diversification in investing?

To mitigate risk, possible diversification strategies include spreading investments across various 

  • Asset classes such as some text
    • Stocks,
    • Bonds, 
    • Real estate, 
    • Commodities,
    • Others (art, wine…)
  • Industries within an asset class likesome text
    • Technology, 
    • Healthcare, 
    • Energy, 
    • Consumer goods, 
    • Financial services. 
  • Geographic regions including some text
    • Developed markets, 
    • Emerging markets. 
  • Investment vehicles such as some text
    • Mutual funds, 
    • Exchange-traded funds (ETFs), 
    • Index funds.

How should one choose an investment diversification strategy?

While financial metrics undoubtedly play a role when building and managing a portfolio, personal convictions also matter a lot. Think about investment portfolio engineering as allocating assets across various categories or "baskets". To simplify, we can imagine that the purpose of one of those baskets is to protect against standard financial market moves. This could include alternative investments such as art pieces or wine bottles, for example. Or, for those aligned with Homaio's convictions, combating climate change through investments in EUAs. Ultimately, the composition of these baskets reflects the investor's values and objectives beyond mere financial returns.

Why are carbon markets and EU emissions allowances (EUAs) good for investment diversification?

Price drivers of standard investment assets (non-diversified portfolio)

The usual price drivers of the S&P 500 and Nasdaq indices are influenced by factors such as corporate earnings, economic indicators like employment, monetary policy decisions, and geopolitical events. Also, market sentiment, investor confidence, and technical analysis and speculation play significant roles in determining price movements within these “standard indices”. Finally, advancements in AI and technology, innovation, and similar sector-specific trends currently contribute a lot to the dynamics in stock markets.

Price drivers carbon markets, a good portfolio diversifier

The price drivers of EUAs are driven by regulatory supply and demand decisions within the European Union's emissions trading system (EU ETS). For example, there has been a price decrease in the past few months, mostly due to the RepowerEU package that modified the supply dynamics. Also, fluctuations in gas and broader energy markets, as well as weather patterns, play significant roles in shaping EUA prices. For example, in the last few months of 2023, there was almost a perfect correlation between gas prices and EUA prices. Finally, carbon market trading behavior and shifts in industrial and manufacturing activity contribute to the dynamic pricing dynamics observed in the EU ETS. The current low manufacturing activity generates less CO2 emissions, so decreases demand for EUAs, introducing downward pressure to the markets.

Correlation with EUAdaily returns

Diversify your investments with EUAs to make sure of the green integrity of your portfolio   

Once an investor decides to include green investments into their “diversification portfolio basket”, they have different options such as ESG funds or green bonds. However, the actual positive environmental impact of those may be debatable. On the other hand, EUAs offer a proven track record in reducing emissions, allowing for individual investors to be completely confident in the sustainability impact of their portfolio.

What do climate finance experts advise on investment diversification?

Soon, we'll be publishing an interview featuring a climate finance expert investor, and professional sustainability advisor. According to our interviewee, a common investor mistake is the absence of portfolio diversification, particularly when it comes to green finance. They advocate for allocating at least 5% to a diversification asset like EUAs, trusting in their characteristics as both a financial asset and a tool contributing to fighting against climate change.

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