Diversification, asset classes and types of risk any investor needs to know about.
When investing, it’s important to understand the balancing act of diversification. Diversification is the practice of investing in different types of assets to reduce risk and maximize returns. By diversifying your portfolio, you can spread out your risk and protect your investments in the long run. When creating a diversified portfolio, it’s important to consider the different asset classes.
This includes stocks, bonds, cash, real estate, and commodities. Each asset class has different risk and return characteristics, so it’s important to understand how they interact and how they will affect your overall portfolio. For instance, stocks tend to be more volatile than bonds, so you may want to have a higher proportion of bonds in your portfolio if you’re looking for lower risk.
On the other hand, stocks tend to have higher returns than bonds over the long term, so you may want to have a higher proportion of stocks if you’re looking for higher returns. The key to successful diversification is to create a balance between risk and return. You want to make sure that you’re not taking on too much risk, but at the same time, you don’t want to limit your potential returns. This is where asset allocation comes into play.
Asset allocation is the process of allocating your investments among different asset classes to create a balanced portfolio. The goal of asset allocation is to create a portfolio that is diversified enough to minimize risk, but still has the potential for growth. It’s important to keep in mind that asset allocation is not a one-time decision. As market conditions change, you should periodically review your portfolio and adjust your allocations accordingly. In the end, diversification is an important part of any investment strategy.
By diversifying your portfolio, you can reduce risk and maximize returns. It’s important to understand the balancing act between risk and return and to adjust your allocations accordingly. With a diversified portfolio, you can protect your investments in the long run.
Understanding the different types of risks in the investment universe is essential for any investor looking to diversify their investment portfolio:
- Market risk. This is the risk of a decline in the overall market that could adversely affect the value of an investor’s holdings. While market timing is generally not recommended, investors should be aware that market conditions can change quickly and they should adjust their portfolios accordingly. This is where upfront planning and portfolio construction is key in order for the investor to not try and time the market.
- Sector risk. This is the risk that a particular sector of the economy could suffer a downturn, resulting in losses for an investor. This is why diversification is so important- an investor should not have all of their eggs in one basket, and they should spread their investments across a variety of sectors/asset classes to protect against sector risk.
- Country risk. This is the risk that a foreign investment could suffer due to political or economic turmoil in the country the investment is located in. Again, diversifying across multiple countries can help protect against this risk.
- Currency risk. This is the risk that a foreign investment could suffer due to fluctuations in currency exchange rates. Again, spreading investments across multiple countries can help to reduce this risk.
- Institutional risk. This is the risk an investment could suffer should the investor be invested with only one institution. Although one can invest all of your funds utilising one platform, the underlying funds should be diversified across multiple asset managers with different house views and investment strategies. Investing all of your funds within one institution is a sure way of taking on a lot more risk resulting in capital loss.
- Emotional Biases. This is certainly not a new buzz word. Emotional biases and emotional investing (see my previous blog post) can really wreak havoc with your portfolio. Buying too high and selling too low or trying to time the market or disinvesting when there is panic in the market is a sure way to capital loss. This is where your financial advisor is an integral part of the planning process. The important point is that you should have a plan, invest and let go. Check in once a year with your investment team or advisor and try not to make rash decisions when the markets are struggling. A well-diversified and planned out portfolio will weather the storms in the long run. One of my favourite sayings are: “What goes down, must come up” and of course, “In the worst of times and in the best of times, money is to be made”
All of the above risks are all important to consider when making investment choices and constructing your investment plan, and diversifying across multiple asset classes can help to reduce the risks associated with investing.