Diversified Investments
Investment Advisers often repeat this line – always diversify your Investments. This is also the common wisdom repeated by the finance textbooks during your college years.
So how do we construct an investment portfolio and what does the above really mean?
Some have attempted to put it simply, going back to historical guidance of not putting all your eggs in one basket; conventional wisdom states that if you were to buy a variety of investments, then the failure of one would not cause your entire portfolio to collapse. However, the reverse is also true, that the stellar performance of any one investment would not reap you amazing returns.
The construction of a diversified portfolio builds on the above, but on slightly more technical aspects. Firstly, one should diversify amongst the different asset classes; investors commonly select equities, bonds, cash and some Alternative Investments such as hedge funds, property or commodities.
These asset classes are chosen, as their returns have historically not been correlated to one another. What this means for example is that when equities make positive returns, it has been shown that bonds make neutral or negative returns. Asset classes with low correlation to each other are good choices for the diversified portfolio as each can perform independently of one another. In recent years, the performance of the metals, energy and soft commodities markets have shown themselves to be able to provide formidable returns, independently of the returns of existing asset classes.
The proportion of each asset class in the portfolio is determined by the risk tolerance of the investor – an investor with a higher risk tolerance can accept greater volatility and hence can incorporate a larger proportion of the asset class with a higher volatility. The significance of volatility in this case is the fluctuation of the asset class’ returns about its mean – an asset with higher volatility can rise higher, but can also suffer sharper falls.
Having decided the proportion of different asset classes in the portfolio, the investor now has to select the components of each asset class. In equities, the famed efficient portfolio model and Capital Asset Pricing Model describe theoretically how to construct an investment portfolio.
In the hedge fund world, funds of hedge funds attempt to take advantage of the neutral correlations of the various strategies to build a diversified hedge fund portfolio. An example of the composition of a fund of hedge funds would be buying into a global macro fund, managed futures, a convertible arbitrage fund and a long-short manager.
The investment community sells the concept of diversification as a way to minimize risk and maximize returns. However, the devil is in the details and in some cases over-diversification has shown to provide the opposite result – giving the investor mediocre returns when the general market has given far better returns, as can easily happen in an equities bull market. What this means is, that the investor has to form an understanding of his or her risk appetite in deciding the level of diversification and the composition of the investment portfolio.
Michael Russell Your Independent guide to Investing
Investments in Mutual Funds and Retirement Plans has NO INSURANCE for LOSSES