What You Need to Know About Diversifying your Investment Portfolio
It has often been said that you need to diversify your portfolio as it cushions against financial markets’ risks. How effective is it? Is it feasible, actionable, or even practical? Financial markets have different types of risk that can be narrowed to two, systemic and unsystematic. The former can hardly be controlled and all that investors can do is accept it. This risk is not diversifiable. It is defined by events such as political instability, flash crashes, war alongside inflation, unfavorable taxes, and variations in exchange rates. On the other hand, unsystematic risk is diversifiable and presents investors with options that shield them from huge market losses.
Diversification, an Approach
Diversification of an investment portfolio can be achieved through different asset allocations on invested capital. Investors, money managers, and financial institutions can opt to have a mix of bonds, stocks, and metals as a diversification strategy. The mix can be given a fund name and marketed to potential investors. Prior market research and analysis back the blending of the different assets to help investors and the fund achieve or exceed set goals.
It is further advised that an investor considers investing in less correlated financial assets. For instance, it would not be advisable to hold an OIL position while holding a similar position on a Canadian Dollar pair such as USDCAD. Canada is an Oil producing country and its main trading currency is the Canadian Dollar (CAD). When Oil prices decline, it significantly weakens the Canadian Dollar’s value showing that these two assets are heavily correlated hence increase risk exposure to an investor holding a portfolio that has the two. Instead, an investor holding an OIL position should add a less correlated financial asset such as a Treasury Bond, this will bring a balance to his or her portfolio.
Additionally, investors have an option to balance growth and defensive assets for maximal gains on diversification. Growth assets can be volatile, their wild moves can be mitigated by defensive assets which are slow-moving in nature but have guaranteed and almost predictable returns. Inferentially, diversification aims at reducing risk, preserving capital, and ensuring stable market returns on an investment portfolio.
Noteworthy, there is a downside to diversification. Diversification has been criticized by seasoned investors who feel that it is a novice’s run to safety guided by short-term market gains. Experienced investors have mastered the markets and have well understood market cycles, patterns, and plays.
A look into the S&P 500 shows that it stood at $ 1,229 on 31st December 1998. Today, S&P 500 is at $4,451, which is a 362% gain. Since 1998, the S&P 500 has seen three strong market crashes and still managed to perform in the long run. The three crashes are the 2000 Tech Bubble, 2008 Financial Crisis, and 2019 pandemic. Critics hold that an investor diversified on a mix of S&P 500 and several less correlated financial assets, would get meager returns compared to one that held the S&P 500 as a single investment. The clear message here is that, even though diversification shields one against significant market losses, it deters investors from getting huge returns from increased market growth that weathers market volatility over time.
Conclusively, investors should be guided by their risk appetite, financial goals, and market experience. People starting their investment journey as well as those who want modest but sure gains should opt for diversification. The propponents of diversification will mostly be guided by a strong market resilience and outlook that can significantly hold losing positions for long periods without emotions but eventually perform over the long term. A few investors have such a strong grasp of market psychology.
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