Thursday, 8 September 2016

Why Diversification Matters (Part 1)

Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.

One of the keys to successful investing is learning how to balance your comfort level with risk against your time horizon. Invest your retirement nest egg too conservatively at a young age, and you run the risk that the growth rate of your investments won’t keep pace with inflation. Conversely, if you invest too aggressively when you’re older, you could leave your savings exposed to market volatility, which could erode the value of your assets at an age when you have fewer opportunities to recoup your losses.

One way to balance risk and reward in your investment portfolio is to diversify your assets. This strategy has many complex iterations, but at its root it’s simply about spreading your portfolio across several asset classes. Diversification can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of stomach-churning ups and downs. Remember, diversification does not ensure a profit or guarantee against loss.

The four primary components of a diversified portfolio

Developed Market stocks – These are shares of US, UK, Japanese and EU companies. Stocks represent the most aggressive portion of your portfolio and provide the opportunity for higher growth over the long term. However, this greater potential for growth carries a greater risk, particularly in the short term. Because stocks are generally more volatile than other types of assets, your investment in a stock could be worth less if and when you decide to sell it.

Bonds - Most bonds provide regular interest income and are generally considered to be less volatile than stocks. They can also act as a cushion against the unpredictable ups and downs of the stock market, as they often behave differently than stocks. Investors who are more focused on safety than growth often favour government or other high-quality bonds, while reducing their exposure to stocks. These investors may have to accept lower long-term returns, as many bonds—especially high-quality issues—generally don’t offer returns as high as stocks over the long term.

Short-term investments - These include money market funds and short-term CDs (certificates of deposit). Money market funds are conservative investments that offer stability and easy access to your money, ideal for those looking to preserve principal. In exchange for that level of safety, money market funds usually provide lower returns than bond funds or individual bonds.

International stocks - Stocks issued by emerging market companies often perform differently than their developed market counterparts, providing exposure to alternative opportunities. If you’re searching for investments that offer both higher potential returns and higher risk, you may want to consider adding some foreign stocks to your portfolio.

Additional components of a diversified portfolio

Sector funds - Although these invest in stocks, sector funds, as their name suggests, focus on a particular segment of the economy. They can be valuable tools for investors seeking opportunities in different phases of the economic cycle.

Commodity focused funds - While only the most experienced investors should invest in commodities, adding equity funds that focus on commodity-intensive industries to your portfolio—such as oil and gas, mining, and natural resources—can provide a good hedge against inflation.

Real estate funds - Real estate funds, including real estate investment trusts (REITs), can also play a role in diversifying your portfolio and providing some protection against the risk of inflation.

Asset allocation funds - For investors who don’t have the time or the expertise to build a diversified portfolio, asset allocation funds can serve as an effective single-fund strategy as the asset allocation is managed for you by the manager.


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