Diversification, a Portfolio’s Best Friend
A well-diversified investment is a portfolio that contains a variety of assets that seek to earn the highest possible return while taking on the least amount of risk. There are two types of investment risk. The first is systematic risk which affects the overall market and is both unpredictable and impossible to avoid completely. The second is unsystematic risk which is associated with unique factors that exist within a company. Furthermore, an investor can avoid unsystematic risk through diversification. A diversified portfolio contains a combination of equities (stock – pubic corporations), fixed income (bonds, pensions, notes, CDs, annuities), commodities (hard assets grouped into 3 categories – agricultural, metals, & energy), and alternative assets (real estate, private equity, futures & forex, hedge funds, venture capital). Diversification in a portfolio functions effectively because these assets respond differently to the same economic occurrence.
In a highly diversified portfolio, the assets are negatively correlated with each other. Asset correlation measures how investments move in relation to each other and the timing of those movements. In the case of negative correlation, when the value of one increases, the value of the other decreases. Portfolio diversification lowers overall risk because, no matter what the state of the economy is, some asset classes will benefit positively. In turn, this offsets losses in the other assets that your portfolio holds. Also, the risk is reduced because it is extremely uncommon that any single event would decimate your entire portfolio. Take, for example, the current times in which we find ourselves. Yes, COVID-19 has had a significant impact on the equities markets, but real estate investors are still receiving rental income payments and reaping the benefits of long-term property appreciation. A diversified portfolio is your best defense against a financial crisis.
Public equities (stock) do well when the economy is in an expansion period, and a rise in real GDP measures this economic growth. Investors are seeking the highest possible returns, so they bid up the price of stocks. In other words, the demand for publicly traded stock outweighs the supply, which causes stock price appreciation. Investors are willing to take on a higher degree of risk from a potential market downturn because they are optimistic and maintain a positive outlook on the future.
In contrast, bonds and other fixed-income securities do well when the economy is in a contraction period (economic growth begins to weaken/lose momentum). During a downturn, the investor’s focus shifts towards protecting their holdings. They are willing to accept lower returns in exchange for a reduction of risk.
Commodities operate uniquely; their prices are influenced by supply and demand. As mentioned previously, commodities are grouped into three categories – agricultural, metals, and energy. So, this would include items like rice, gold, and crude oil. To understand how the price of a particular commodity is calculated, let’s say, for example, a region where rice is grown is experiencing a severe drought that limits the supply of rice. This event would directly impact the price of rice and cause it to rise. Another example, if there were an additional supply of oil, then the price per barrel would fall. The bottom line is, commodities do not follow the phases of the business cycle as closely as stocks and bonds.
Alternative assets are great because they allow investors to put investable cash into assets that are not available on publicly traded markets. Also, they enable individuals to invest in assets in which they may have a lot of knowledge. For example, you may not be a licensed financial broker and, therefore, not know what stocks and bonds to select. However, if you are an experienced real estate professional who is aware of numerous investment properties that are currently undervalued relative to the market, it could provide peace-of-mind investing.
You may be asking yourself, what is the perfect amount of each asset class that you should hold in your portfolio to ensure it is diversified? The answer is, every investor is different and has unique goals and time horizons. However, investors use a strategy called asset allocation to determine the precise mix of equities, fixed income, commodities, and alternatives to incorporate into their investment portfolio. It depends on how comfortable you are with managing different levels of risk, what stage you are at in life, and your overall goals. For example, equities are typically regarded as riskier assets to hold than bonds. If you need the money in the next couple of years for retirement, then your investment portfolio should hold more bonds than someone who is younger and could wait long-term for his or her portfolio to recover losses. Another example, say you are currently in retirement and need cash flow to cover daily living expenses. In this case, your portfolio should probably hold a higher percentage of fixed income/alternative investments. That ensures that you are continually receiving a flow of income. The percentage of each type of asset class held in your portfolio depends on your specific life goals.
You may also want to consider rebalancing your portfolio. Take into account where the business cycle is and your current situation. Rebalancing is the process of adjusting the weight percentages of your portfolio’s assets. Rebalancing involves occasionally buying or selling assets in your portfolio to get back to your desired level of asset allocation or risk tolerance. Moreover, rebalancing will assist you with sticking to your original investing plan, regardless of market volatility.
In conclusion, diversification will assist you in minimizing risk to reach the highest possible investment return. It is important to note that asset allocation, rebalancing, and diversification cannot make your portfolio completely immune to risk and prevent you from losing money. Still, these strategies can be helpful and may help you reduce the effects of market uncertainty and potentially limit significant losses.
If you have any questions about this article and would like more information, please feel free to contact Midland at 239-333-1032 or www.midlandtrust.com.
MIDLAND TRUST IS NOT A FIDUCIARY: Midland’s role as the administrator of self-directed retirement accounts is non-discretionary and/or administrative in nature. The account holder or his/her authorized representative must direct all investment transactions and choose the investment(s) for the account. Midland has no responsibility or involvement in selecting or evaluating any investment. Nothing contained herein shall be construed as investment, legal, tax, or financial advice or as a guarantee, endorsement, or certification of any investments.