Greetings traders and welcome back to another Survival Guide.
Chris here, bringing you some more information.
Today, we're going to be talking about portfolio diversification.
A lot of rhyming going on today.
With that, we're going to cover exactly what it is, how
it works, and why you should probably consider it yourself.
But without further ado, let's get going through our disclaimer
so we can jump into that juicy material.
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Portfolio diversification is an important concept in investing
and has been used by financial planners for some time in
order to mitigate risk, but what really is it?
Well, it is a strategy per say of combining different securities
to reduce the overall investment of a portfolio's inherent
risk. Diversification can mitigate the risk and volatility
in a portfolio by reducing the number and severity of the ups and downs
that the portfolio may experience. A key variable in portfolio
diversification is what is called "correlation." Finding assets
with relatively low correlation to equities and bonds is
one key consideration of portfolio managers and financial
planners all around the world.
However, portfolio diversification is not something that
will simply guarantee profit or always protect against loss,
but when done correctly, can absolutely aid in those categories.
Let's take a moment to talk about the word correlation.
The correlation coefficient is a measure of how closely related
two data series are. It measures the direction and extent of
linear association between the two variables. Positive linear
association between two variables occurs when the correlation
coefficient is greater than zero. Negative linear association
occurs when the correlation coefficient is less than zero.
This is a way to describe how closely related
the price path of two assets are. The coefficient can
have a maximum value of 1 and a minimum value of negative
1. Financial investment may have high, low, or no correlation
at all when comparing two assets. Investing in securities with low
or no correlation in a portfolio helps in constructing a
diversified investment portfolio as a general concept.
However, correlation is not necessarily causation.
If A is positively correlated with B,
it could mean that A explains B, B explains A, or there could
be a spurious correlation in general. Further analysis should
always be carried out. The correlation of investments can
fluctuate along short term or long term periods.
It is important to understand the correlation of a portfolio's
investments in the context of volatility. In a period of
high market volatility, such as an economic downturn, correlations
may move towards positive coefficient and investments may
follow the downturn. The purpose of portfolio diversification is portfolio
risk management at the core. A well-diversified portfolio
will reduce the volatility of a portfolio because not all
the investments are going to be moving in the same direction
together. Therefore, holding a variety of low or no correlation
assets can reduce unsystematic risk. An investing strategy
that holds investments across asset classes, like equities,
fixed income, commodities, and alternative investments like
futures and forwards, is
less likely to experience a severe loss relative to a non-diversified
portfolio. Diversification could also be achieved within an
asset class across geographical regions, currencies,
and time frames as well. Diversified portfolios can have a lower exposure to risk
as we were discussing, but they can also improve portfolio
stability and earning potential. To build a diversified portfolio,
one should have a clear understanding of our investment goals
as well as our risk tolerance.
If we are investing with the main objective to accumulate
wealth for a retirement period, we could have a risk objective
in a time period different than someone who is investing
for a short-term gain in the market. Here,
we have the two main concepts why portfolio diversification
is a desirable outcome for most. The first is
risk management. Risk reduction is a key principle of portfolio
diversification and different types of risk impact portfolio
construction and wealth building capacities. Unsystematic
risk, also known as diversifiable risk, is related to a specific
asset class or sub asset class. Such risks may include company
specific risk, sector risk, industry risk, or risk within a
financial system itself. To reduce the risk of loss from unsystematic
risk, an investor's portfolio strategy should be to diversify
across investments that do not share the same unsystematic
risks. This could limit losses from a particular company,
asset class, region, or industry, and at the same time, may increase
earning potential in a portfolio by increasing the portfolio
efficiency overall. Systemic risk is inherited in the market
as a whole, and such risk could be things like interest rates and inflation.
It is difficult to economic recessions or inflation, but holding
a diversified portfolio in the long run can reduce losses
in case of any of these events materializing. Beta coefficient
can also help in measuring the degree of systemic risk of
a particular investment. A measure systematic risk of an
investment or a portfolio, relative to the market as a whole.
Diversifying across investments with lower betas may help
in reducing some type of systemic risk. Then we have the
higher potential return aspect. A diversified portfolio may
increase stability in the portfolio in terms of risk. A more
stable investment portfolio may result in a better portfolio
return overall. It should be noted that portfolio diversification doesn't
eliminate the risk entirely, but when it's structured well,
it can earn better risk-adjusted returns in the long run.
The Markowitz Modern Portfolio theory is a common approach
and strategy when traders are looking to diversify their
portfolio. It was introduced by Harry Markowitz in 1952 and
is one of the most famous portfolio diversification strategies
that traders are still using today.
The basic premise of the theory is structuring an investment
portfolio to maximize return at a given level of the risk
curve of the efficient frontier.
This is also known as the "mean variance framework," otherwise MVO. This was developed,
once again, by Markowitz. All portfolios that fall below the
curve of the frontier, as you can see here, are considered
not investable due to taking more risk for the same level
of return. According to Markowitz, an efficient portfolio
is one that lies along the efficient curve and represents
all efficient portfolios. Markowitz recognized that adding
assets in a portfolio with low or no
correlation reduced risk. Measured by standard deviation,
of course, by more than just the weighted average risk of
the assets themselves.
Therefore, mean-variance optimization is a model for determining
the right mix of assets to achieve a desirable expected return
on a portfolio, given a level of risk. MVO is widely understood
and enables an investor to identify portfolios with the best
risk return trade-off, also referred to as the Sharpe Ratio.
Therefore, this a allocation approach may set optimal diversification
levels for a portfolio for those of you that are looking
for a strategy to follow along. If you are interested in diversifying,
then you'll be happy to hear that there's really no shortage
of assets to choose from. Portfolio construction could have
different asset classes as a mean of diversification just
by itself. An asset class is a group of securities that share
similar characteristics and behavior. There is a loss of diverse
asset classes that could be further broken down into sub
classes. But in general, a portfolio with a broader mix of
asset classes will have broader diversification. Some
of these major asset classes include equities, fixed income,
cash, cash equivalents, and alternative investments. With equities,
stocks represent one of the riskiest asset classes and provide the opportunity
for higher growth over the long term.
However, in short-term, stocks carry greater risk due to market
fluctuations. Equities in portfolio provide diversification
when combined with other assets. Moreover,
equities increase in prices, offering capital appreciation
provide income in the form of dividends and could serve as
a hedge against inflation. Then with fixed income, globally
fixed income represents one of the largest asset classes
in financial markets. Fixed income investments provide diversification
in a portfolio and provide a protection against inflation
as well. Diversification in an equity and fixed income portfolio,
is generally higher due to lower correlation between these
two asset classes. Then with cash and cash equivalents, these
include money market funds and short-term investments such
as a time deposit in a bank account. Money market funds are
low return assets that can be liquidated rather quick to
obtain the cash. Due to relatively lower risk of money market
funds in time deposit, the returns are relatively low in this category.
Then we have alternative investments. Alternative investments
have different risk and return characteristics, which differ
from those of traditional stock and bond investments. Examples
of alternative investments could include futures and forwards,
private equity, hedge funds, real estate, commodities, and even
private credit. These investments are perceived as long-term assets that
may require investors to have a longer-term horizon.
Let's talk about building a portfolio diversification strategy.
Investing is a dynamic process that requires regular adjustments
and modifications as market conditions change. A proper investment
strategy and process is important to have a diversified portfolio.
To build a portfolio diversification strategy,
there are three substantial steps of importance, and they
can be summed up with; create an investment plan, invest according
to the plan, and manage the investment plan.
With create an investment plan, this is a tailored investment plan
that should be crafted defining goals, time horizon, and risk
tolerance should all be crucial in this step. Then, with investing
according to the plan, after defining our goals, risk capacity,
the time horizon, choosing a mix of asset classes that are
considered appropriate for achieving those goals, is the next
step. A balanced allocation between asset classes should be
achieved in order to build a diversified portfolio.
Once the right mix of asset classes is selected, then
implementation can be executed. Here, we have manage the
investment plan. Portfolio monitoring is a regular step in
portfolio management. Maintaining a portfolio according to
the investment plan involves monitoring, which is when we're
evaluating portfolio performance and risk periodically for
changes in any strategy, and we have rebalancing, which is
when portfolio allocation may drift from the investment plan
due to price movements as a result of market performance. Rebalancing
may be needed to reset the portfolio according to our original investment plan.
Rebalancing may be done in a systematic or discretionary
way, depending on the investment strategy.
Then finally, we have the revisit the investment plan
portion of this, and this is advisable that at least once
a year we do this, or when financial goals and risk tolerance
change. The investment plan should be revisited to ensure
it's still answers the investor's goals
and risk tolerance because after all, we are all different
and all of our goals are different.
When constructing a diversified investment portfolio, investors
should have optimal asset classes and number of investments
in the portfolio according to the investment objectives. Investors
can easily over-diversify their portfolio by including many
investments and funds, but this does not lead to an optimal
outcome. Over-diversifying will lead to a loss of returns
that could exceed the benefit of reducing the risks.
We don't want to overdo it. When adding low or negative
correlation investments in a portfolio, each investment reduces the portfolio risk, but
also reduces the expected return. The optimal number of investments
in the portfolio should be enough to eliminate the unsystematic
risk, but yet have investment in the best securities with
the highest potential of increasing returns. Another potential
mistake that traders make when diversifying is to do it just
for the sake of diversification.
It should be clear that diversification should be part of
a portfolio strategy and construction.
However, we don't want to make investments in weak securities
solely for diversification. Investing in low-quality sectors
or asset classes will not necessarily improve our portfolio
diversification process or our returns.
The herding behavior that traders develop is defined in a
broad way as an investor following the investment behavior
of a crowd, and this is another mistake when diversifying
the portfolio. Chasing hot sectors or markets may drift investors
from investment planning and portfolio strategy, thus hurting portfolio diversification.
Trends in markets come and go, and investors may hurt their
portfolio by following the herd style behavior blindly.
In conclusion, a diversified portfolio is a means to help you reach your goals
when you personalize it for you. The traditional method of
doing a 60/40 ratio of equities and bonds has long since
been under scrutiny, and realistically, the most successful
portfolio strategy is going to be one that's tailored specifically
to your needs. As long as you understand the concepts, and the
goals, and the benefits that can be provided by having a diversified
portfolio, and by doing it correctly,
then at that point, it's really up to you to decide exactly how you want to do it.
I strongly encourage spending a little bit more time checking
out the possible outcomes out there for you and see if it
fits your trading style. But until next time folks, I will see you soon.
Please click that like and subscribe button before you go
and I'll see you in the next one. Cheers, folks!