The gist of diversification is strive to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks like unit trust funds will yield the most cost-effective level of risk reduction. Investing in more securities will still yield further diversification benefits, albeit at a drastically smaller rate.
Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments would allow an investor to have a small cushion of protection against losses due to an American economic downturn.
Since the mid-1970s, it has also been argued that geographic diversification would generate superior risk-adjusted returns for large institutional investors by reducing overall portfolio risk while capturing some of the higher rates of return offered by the emerging markets of Asia and Latin America.
Most non-institutional investors have a limited investment budget, and may find it difficult to create an adequately diversified portfolio. This fact alone can explain why mutual funds have been increasing in popularity and make headway to offer offshore funds where money will be invested in regional share markets. Hence buying shares in a mutual fund can provide investors with an inexpensive source of diversification.
The Hype of Diversification
The term of "Diversification" in finance and investment is closely related diversification of money into different and various asset class to minimize the risks of investment or simply put it as asset allocation of various asset classes namely stocks, bonds, unit trust, real estates, commodities and etc. However, one of the investment diversification that is rarely capture our attention is "Currency Diversification".
Recent critics of asset allocation, however, have pointed out that due to factors such as globalization, many assets including stocks now move in lock step. This trend, they say, is illustrated in the 2008 crash when all sorts of assets fell in tandem, supposedly revealing that the benefits of diversification are ephemeral.
A quick look at the core stock classes in 2008 shows that pain was evenly spread across every major category with U.S. stocks down 36.2 percent, foreign developed markets down 43.4 percent, emerging market stocks 52.9 percent, and even the nontraditional classes of REITS and commodities hit with declines of 37.6 percent and 31.9 percent respectively.
Where is the non-correlation in this asset allocation? These facts, the critics point out, prove that the asset allocation models of the past are now bunk and in need of a desperate overhaul. 2008 is said to have sounded the death knell for all of modern finance. In response, one idea that has gained traction among some managers is the notion of adding global currencies as a new type of uncorrelated asset class.
Globalization has created many reasons for increasing the diversification of an investment portfolio outside of the home country, particularly in terms of diversifying currency, that are crucial for investors to consider now.
Next we see what is currency diversification and why should you add currencies into your Mix?
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