The ChoosaBroker Trading Academy

1.4. Diversification

Course Description

No matter what you plan to invest in, whether it be stocks, bonds or commodities, don’t put all your eggs in one basket. It is hard to overstate the significance of diversification of investment portfolio. Concentrating your portfolio around one single instrument is the single biggest reason why a large number of investors fail to meet their financial goals. In this lesson, we will learn about:

Why Diversification Matters?

Diversification is an investment management technique that reduces risk in a portfolio by allocating capital among multiple financial instruments. No one can correctly forecast how an asset class will behave in the future. By spreading your investments across different instruments like equities, bonds, gold, cash and real estate, you are reducing the likelihood of underperformance in a single market affect your entire portfolio’s returns.
A portfolio can also be diversified within each asset class. Let’s say you have a portfolio comprising solely of airline stocks. If, due to some labour dispute, the airline pilots decide to go on an indefinite strike, all flights will be cancelled. The prices of the airline stocks will immediately take a beating, resulting in significant erosion of your portfolio’s value. However, if you counterbalanced the airline stocks with investments in few railroad companies, not only will it help mitigate the risk and volatility in your portfolio, but there is a very good chance that the prices of the railway stock will climb, as passengers increasingly turn to trains as an alternative means of transportation.

Components of a Diversified Portfolio

To build a well-diversified portfolio, an investor should seek assets whose returns ideally tend to move in opposing directions. That way, even if a segment of the portfolio is diminishing in value, the rest of the asset index is more than likely to appreciate, or at least not decrease as much.
The four primary components of a diversified portfolio are listed below –
  • Stocks

  • Equities, both domestic and international, represent the most aggressive chunk of a portfolio and offer the maximum returns over the long term. However, the higher growth potential comes laden with greater risk. The equity portion of a portfolio can be further diversified in to defensive, cyclical and growth stocks, with the latter two accentuating the returns, while defensive stocks help provide cushion during market downturns.
Bonds

Bonds provide regular interest income and are less volatile than stocks. Generally, bonds pay interest twice a year. If held to maturity, bondholders also get back the entire principal invested. Bonds are integral to a portfolio because of their inverse relationship with stocks. When stock prices go down, bond prices go up, and vice-versa, making bonds an ideal shield against declines in equity markets.

Short-term Investments

Money market instruments and short-term certificates of deposit are ultra conservative investment vehicles that provide stability to a portfolio and offer easy access to capital. In return for that level of safety, money market assets typically generate lower returns than both bonds and stocks. Transactions in money market instruments are wholesale, meaning they happen only in large denominations. Individual investors can instead opt for money market funds that offer the potential for higher yields than conventional cash equivalents.

Gold

Modern portfolio theory advocates that a portfolio’s performance can be improved by investing in assets that have low correlation to each other. Gold is one such instrument that moves independently of both stocks and bonds. Gold has also historically proven to be an excellent hedge against inflation, because its price tends to increase with a rise in the general price level.

Diversified Portfolio Models

An investment portfolio can be broadly classified in to 3 categories – income, balanced and growth – based on the risk profile and return expectation of an investor. Let us see how each of these performed over a 91-year period starting 1926.

Income

An income-oriented investor seeks steady income flow with minimal risk to capital, and is comfortable with modest long-term appreciation of principal.

100% Bonds

20% stocks – 80% Bonds

Balanced
A balanced investor seeks moderate growth of principal and is willing to tolerate short-term fluctuations in the portfolio’s value.

40% Stocks – 60% Bonds

50% Stocks – 50% Bonds

70% Stocks – 20% Bonds

80% Stocks – 20% Bonds

**US equity market returns were calculated by computing the returns of the S&P 500, the S&P 90, the Dow Jones Wilshire 5000, the CRSP US Total Market Index and the MSCI US Broad Market Index during separate periods of time.
**Bond market returns in the US were measured by using the Citigroup High Grade Index, the S&P High Grade Corporate Index, the Bloomberg Barclays US Aggregate Float Adjusted Index and the Bloomberg Barclays US Aggregate Bond Index during separate time intervals.
** The index that was deemed to be the best representation of the referenced market during a particular time-period was used.

Advantages of Portfolio Diversification

Diversification is a useful investment strategy because of two main reasons. First, portfolios with multiple assets carry less risk compared to concentrated portfolios. Second, diversification provides investors with the opportunity to add riskier assets to their portfolios without lifting their overall risk exposure. It is easy to understand why diversified portfolios involve lesser risk. Diversification also allows investors to partially investment in asset classes in which they normally wouldn’t feel confident assigning 100% of their capital. For example, many retirees or people on the verge of retirement think they are reducing the risk component in their portfolios by offloading all of their stock holdings. Multiple studies have shown that by retaining at least a small percentage of stocks, conservative investors can actually boost their returns when compared to a portfolio composed solely of fixed-income instruments.

Final Few Notes

The primary goal of diversification isn’t to augment returns but to limit the impact of volatility on your portfolio. However, market risk can never be completely eliminated. The value of a diversified portfolio usually takes time to manifests itself. Unfortunately, a majority of investors fail to fully realize the gains because of lack of self-discipline.

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