Question: I have heard about the benefits of diversification. But how does one exactly execute it? Is it enough that I spread my money equally among several investments? What is a good number of investments to spread my money over? And if the amounts per investment need to vary, how do I know how much to buy of which investment?
Answer: Let us first define what diversification means.
Diversification is the process of spreading your money among investments for the purpose of reducing exposure to risk brought on by such investments. In a way, farmers had been practicing diversification a very long time through intercropping. While waiting to harvest crops that take a relatively longer time to ripen, farmers plant other crops that can sustain them for the meantime. And if the major crops fail, the loss would have been mitigated by the revenues—albeit smaller—from the practice of intercropping.
In finance, the prices of investments do not move in perfect harmony.
If the prices of investments do not move in synchrony, a diversified investment portfolio will have less variance than the weighted average variance of its constituent assets, and often less volatility than the least volatile of its constituents.
Diversification is one of two general techniques for reducing investment risk. The other is hedging. But let us not pursue hedging for now after that already nauseating definition of diversification.
There are many ways to execute diversification. The more common way is to diversify among and within asset classes, with the basic types of asset classes being stocks, bonds and money market instruments.
By diversifying among asset classes, you will need to choose how much of your money you will invest in stocks, bonds and money market instruments.
Research shows that portfolio performance is 92 percent of the time determined by asset allocation, 5 percent through stock selection, 2 percent through the timing of buying and selling, and 1 percent through sheer luck.
Despite research findings, some still seek to be expert pickers by allocating within asset categories, particularly within stocks. So if it is your cup of tea, you could allocate among companies in different industries, with different asset sizes (i.e. large capitalization vs. low capitalization), and more. It is, however, with diversifying within asset classes that fundamental and technical analyses on the underlying companies of investments take on more importance.
There is a way to find out what determines a portfolio’s return and this is by running a performance attribution analysis. Just like with diversification, the math is too nauseating and complicated to include in this article. Suffice it to say that performance attribution analysis measures the parts of a portfolio’s return that are attributable to asset allocation, stock selection and the interaction of both.
You can also allocate your money among investments in different geographies without even having to leave the country. There are pooled funds now being offered by private equity funds that allow for investing in other geographical locations as well as in different asset classes employing varied investment strategies. The two basic pooled funds allowing for such foreign land investing are fund of funds and feeder funds.
A fund of funds solicits money from local investors and invests them in different funds abroad. A feeder fund solicits money from local investors and invests them in one fund abroad. Again, each of the underlying funds will also be practicing diversification in one form or another. Asset classes can range from the traditional categories to commodities and even derivatives and options.
It follows that if money is invested abroad, you will automatically be doing currency diversification as well.
By the way, if you choose to simply buy pooled funds, you will not need to buy several if they are in the same asset category. Either by regulation or practice, pooled funds already employ diversification.
For example, both Philippine mutual funds and unit investment trust funds are restricted from investing more than 15 percent of their net assets in any one investment security.
Regardless of the type of diversification, the first step is still to know your own target return and initial risk preference. And your expected portfolio return and risk must meet your said target return and initial risk preference. I underscore “initial” because for people who are late in the game in investing, they normally need to level up on the risk that they should be taking just to meet their target return. - business.inquirer
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