If you are an investor, there will always arise the need to diversify your portfolio in order to protect yourself in the case of a market crash.
And contrary to public opinion, diversifying your portfolio isn’t as complicated as it sounds.
Most people would rather save their money in a bank somewhere than invest, mainly because of the risks associated with investing.
Many used to dread the thought of risking their hard-earned money until they understood one of the most basic and effective risk management techniques—diversification.
You’ve probably heard of the term diversification. In finance, diversification refers to the process of assigning capital in a manner that decreases exposure to risk.
The rationale behind diversification is simple—on average, investment portfolios composed of different kinds of investments yield higher returns and pose a lower risk compared to any individual investment within the portfolio.
In finance, diversification refers to the process of assigning capital in a manner that decreases exposure to risk.
Best way to balance your portfolio?
The reality is that there isn’t a one size fits all format when it comes to balancing your investment portfolio.
Just like there isn't one diet that fits everyone. Depending on your body fat makeup and what you're trying to accomplish (increasing endurance, building muscle, losing weight), the proportions of protein, fat and carbohydrates you should consume can vary widely. Same is the case when diversifying your asset selections.
The reality is that there isn’t a one size fits all format when it comes to balancing your investment portfolio.
As long as humans continue to vary in age, income, net worth, desire to build wealth, propensity to spend, aversion to risk, number of children, hometown with its concomitant cost of living and a million other variables, there'll never be a blanket optimal portfolio balance for everyone.
The old rule of thumb used to be that you should subtract your age from 100 - and that's the percentage of your portfolio that you should keep in stocks. For example, if you're 30, you should keep 70 per cent of your portfolio in stocks. If you're 70, you should keep 30 per cent of your portfolio in stocks.
The rationale behind this method is that young folks have longer time horizons to weather storms in the stock market. In theory, they would be safe to invest heavily in growth-oriented securities like stocks. Historically, equities have outperformed other types of assets in the long run.
But if you’re nearing or in retirement, you’d need your money sooner. So, it may make more sense to invest more heavily in securities such as fixed-income investments that are generally considered “safe”, and you are considered risk-conservative.
If you are risk-conservative and want minimal risk to your portfolio, you can divide 50 per cent of your portfolio to bonds, 30 per cent to short-term investments, 14 per cent to domestic stocks and rest 6 per cent to foreign stocks.
And indicative of the thumb-rule, if you are at the other end of the age spectrum, and you are young and adventurous – you are considered risk-aggressive.
Which means you could have a sample portfolio with 60 per cent weighted towards domestic stocks, 25 per cent on foreign stocks and rest 15 per cent towards bonds, commodities, real estate or cash.
If you are risk-conservative and want minimal risk to your portfolio, you can divide 50 per cent of your portfolio to bonds, 30 per cent to short-term investments, 14 per cent to domestic stocks and rest 6 per cent to foreign stocks.
If you're new to commodities, you should start out with a relatively modest amount — anywhere between 3 and 5 per cent of your portfolio — to see how comfortable you feel with this new member of your financial family.
Test how commodities contribute to your overall portfolio’s performance during one or two investing quarters. If you’re satisfied, you can gradually increase your percentage.
Financial planners recommend a 5 per cent to 10 per cent allocation of your overall portfolio to real estate.
Owning your own home is not real estate investing, advisors stress.
For most investors, buying a real estate investment trust, which can be purchased in either a mutual or exchange-traded fund, is the easiest way to go.
Sample portfolio
Here is a hypothetical portfolio that includes commodities along with other asset classes. This could be a sample portfolio for an average investor who wants exposure to both liquid and non-liquid (real estate) assets.
The portfolio can consist of 30 per cent stocks, 30 per cent bonds, 20 per cent managed funds, 10 per cent real estate and 10 per cent commodities.
A diversified portfolio helps reduce the overall volatility of your market exposures. Having unrelated assets increases your chances of maintaining good returns when a certain asset underperforms.
Now that we have learned the different ways one can diversify, let’s look in detail at the different assets that you are customising your portfolio with and the science as to why you should or shouldn’t invest into each of these assets.
How to diversify one’s portfolio?
For many financial goals, investing in a mix of stocks, bonds, and cash can be a good strategy. Let’s take a closer look at the characteristics of the three major asset categories.
Stocks
Stocks have historically had the greatest risk and highest returns among the three major asset categories. As an asset category, stocks offer the greatest potential for growth.
But the volatility of stocks makes them a very risky investment in the short term.
As an asset category, stocks offer the greatest potential for growth. But the volatility of stocks makes them a very risky investment in the short term.
Large company stocks as a group, for example, have lost money on average about one out of every three years. And sometimes the losses have been quite dramatic.
But investors that have been willing to ride out the volatile returns of stocks over long periods of time generally have been rewarded with strong positive returns.
Bonds
Bonds are generally less volatile than stocks but offer more modest returns.
As a result, an investor approaching a financial goal might increase his or her bond holdings relative to his or her stock holdings because the reduced risk of holding more bonds would be attractive to the investor despite their lower potential for growth.
You should keep in mind that certain categories of bonds offer high returns similar to stocks. But these bonds, known as high-yield or junk bonds, also carry higher risk.
Bonds are generally less volatile than stocks but offer more modest returns.
Cash
Cash and cash equivalents - such as savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds - are the safest investments, but offer the lowest return of the three major asset categories.
The principal concern for investors investing in cash equivalents is inflation risk. This is the risk that inflation will outpace and erode investment returns over time.
Stocks, bonds, and cash are the most common asset categories. These are the asset categories you would likely choose from when investing in a retirement savings program or a college savings plan.
Not all eggs in one basket
Even if you are an investor just starting out, you would have by now heard of the phrase, ‘do not put all your eggs in the same basket’. So, the first thing to remember is to not put all of your money in one stock or one sector.
There are many other options you can consider, apart from stocks, bonds or cash.
Some investors include asset categories like commodities, exchange-traded funds (ETFs), and real estate investment trusts (REITs) within a portfolio.
Exchange-traded funds or ETFs offer the cheapest and simplest way to get into the stock and bond markets. And what makes it popular is that ETFs trade like stocks — you can buy and sell them whenever the markets are open.
ETFs also offer investors diversification because a single ETF may hold stocks or bonds for hundreds of foreign companies. Winners compensate for the losers.
ETFs are so varied that they give investors thousands of ways to bet on countries (such as China), industries (robotics, for example), or products (like video games).
Investment portfolios with real estate funds, which include real estate investment trusts offer protection against inflation.
The funds also provide unique opportunities in real estate you wouldn’t otherwise be able to take advantage of on your own.
Equity funds which focus on commodities such as gas, minerals, oil, etc. can protect your portfolio against inflation.
The funds also shields investors from the risks associated with commodities since commodity investing is recommendable for seasoned investors only.
Investors also use derivatives to diversify their portfolio.
Investors typically use derivatives for three reasons: to hedge a position, to increase leverage or to speculate on an asset's movement. Hedging a position is usually done to protect against or to insure the risk of an asset. Investors also use derivatives to bet on the future price of the asset through speculation.
Investments in these asset categories typically have category-specific risks. Before you make any investment, you should understand the risks of the investment and make sure the risks are appropriate for you.
Consider also index, fixed income funds
You may also want to consider adding index funds or fixed-income funds to the mix.
Investing in securities that track various indexes has been proven to be a strong long-term diversification investment for your portfolio.
These funds often come with low fees, which is another bonus. It means more money in your pocket. The management and operating costs are minimal because of what it takes to run these funds.
Also, don't just stick to your own home ground – meaning think of investing beyond your home country and go global. This way, you'll spread your risk around, which can lead to bigger rewards.
However, ensure you keep yourself to a portfolio that's manageable. There's no sense in investing in 100 different vehicles when you really don't have the time or resources to keep up.
Try to limit yourself to about 20 to 30 different investments.
Don't just stick to your own home ground – meaning think of investing beyond your home country and go global. This way, you'll spread your risk around, which can lead to bigger rewards.
Importance of asset allocation
The traditional balanced portfolio comprises 60 per cent stocks and 40 per cent bonds. However, several veteran investors recommend that asset allocation should be based on your age.
Younger investors are in a better position to take on more risk than older investors are. Younger folks have a lot more time to recover if they lose money.
That’s young investors should be aggressive with stock investments and become less aggressive over time, as they approach retirement age.
For example, let’s say that you’re in your 30s. You should have a portfolio that’s 80 per cent stocks and 20 per cent bonds. By the time you reach your late 50s and beyond, your portfolio should be a conservative 50-50 mix.
Real world example of diversification
Including international bonds, commodities, hedge funds, and REITs in the portfolio would have reduced the loss to 16 per cent during the 2008 crash.
So by “putting all your eggs in one basket,” you’re actually hurting yourself financially.
Diversification will reduce risks and make your returns more stable over the long-term. But it doesn’t have to be complicated.
By “putting all your eggs in one basket,” you’re actually hurting yourself financially. Diversification will reduce risks.
_resources1_16a4a1613d8_small.jpg)
