During the boom in the market, it is almost impossible for a supplier to sell a stock at a price which is less than the purchase price. However, we can never be certain what the market will behave at any given time; we must not fail to remember the significance of well-diversified investments or portfolio, regardless of the market situation.
To establish an investment strategy that offsets the possible losses in a market, the investor class suggesting the same as the real estate marketer advocates for buying a home by focusing on “location”. In simple terms, you should never put all of your eggs in the same basket. This is the point where rational people need diversification. Before going into details let clear the concept of diversification and diversified investments.
What Is Diversification?
Diversification is a big challenge for private investors, fund managers, financial planners, etc. It is a basic managerial tactic that combines diverse investments/assets into a single portfolio. Diversification is based on the idea that diverse investments will give a higher return. It also indicates that by using diversification investors will face a lower level of risk.
What Is Diversified Investment?
The diversified investment is a diversified portfolio of assets that achieves the highest return at the cost of lower risk. Usually, diversified portfolio includes a mix of commodities e.g. gold, diamond, etc., fixed income, stocks, and equities. Diversification is a successful tactic or practice because different assets behave differently against the same economic event. If someone faces loss in one investment and he also faces benefiting the other investment.
One of the major characteristic of a diversified investment or portfolio that all the assets in which a person invested, are not correlated. As the value of one asset increases, the value of the other asset decreases regardless of the economic conditions of the country. This reduces the overall risk as some asset classes will benefit regardless of the economic situation. This thing compensates the losses in the other assets (if any). The level of risk is less in it because economic history told us that it is very rare that a single economic event destroys the whole diversified investments or portfolio. Consequently, the diversified investments or portfolio is the best defense for anyone against any anticipated or unanticipated financial crises.
Diversification and Diversified Investments are not new concepts in this modern era. In retrospect, we can sit back and critique the reactions and movements of markets that stumbled during the stock market crash (known as dotcom crash) and the Great Recession.
Keep in mind that diversified investments or portfolios are an art and not a hasty reaction. Therefore, before diversification becomes a necessity, it is need of time to practice disciplined investment. The research studies show that on an average investor “reacts” to the market when already 80% of damage has been done. In many countries, investors follow the rule of “a good offense is your best defense.” The well-diversified investments or portfolio with a combination of a five-year investment horizon can withstand most storms.
How Diversified Investments Work: An Example
Inventories, equities, and stocks are doing well when the economy is growing. Investors are looking for the maximum returns and therefore offer the share price. They are optimistic about future returns and willing to accept higher adverse risks.
The fixed-income securities and Bonds are beneficial when the economy slows because in this phase investors are looking for saving their assets. Therefore, they are ready to accept the lower rate of returns for the risk reduction.
Product prices vary depending on supply and demand. The products are gold, oil, and wheat. For example, wheat prices will rise during the drought which limits the supply. On the other hand, the prices of oil will fall when supply increases. Consequently, commodities are less likely to follow economic cycles than equities and bonds.
Six Recommended Classes for Diversified Investments
The diversified investments or portfolios should consist of a combination of below-mentioned classes.
1. Foreign Fixed Income
This includes issues related to both governments as well as the corporate sector. This fixed income offers safety/protection in case of a declining dollar rate. Therefore, foreign fixed income is far safer than stocks.
2. Foreign Stocks.
The best foreign stocks are stocks of companies from industrialized and emerging countries. By investing abroad you can attain greater diversified investments and diversification. Due to the faster growth rate of emerging markets, higher returns can be obtained. However, they have more risk because in emerging markets central bank has fewer safeguards are vulnerable to political change and are less transparent.
The benefit of foreign investment is that it protects against the declining rate of the dollar (assume your country’s currency). Your domestic industry increases the exports when the dollar is strong or your currency depreciated or inflation increases and when you currency become stronger or appreciated or deflation occurs then exports of other country increases.
3. Domestic Fixed Income
The safest domestic fixed income providing things are T-Bills and saving bonds. These things are backed by the federal government. In developed countries like USA municipal bonds are also offered which is also a very safe investment. Short-term bond funds and money market funds are also offered and you can also invest in these safe securities. Further, corporate bonds offer higher returns with higher risk. The highest returns and risks are obtained by speculative bonds.
4. Domestic Stocks
Companies of different sizes should be involved. Market capitalization is the indicator of the market size. The stocks of the small, mid and large-cap should be a part of each portfolio.
Commodities include precious natural resources like oil, real state, and gold. During the stock market crash, gold does not affect badly why gold is considered as a better investment during the market crash and recommended as part of any diversified investment or portfolio. The research studies revealed that gold is the best thing whose prices increase dramatically after 15 days of a market crash. This is the reason that the majority of investors took it as part of their diversified investments or portfolios. It does not correlate with bonds and stocks and best defense against inflation. During deflation, investment in gold is not recommended.
6. Equity in your Home
Equity in your own home should be considered as kind of investment. The investment and financial advisors do not consider as an investment rather as a consumable product like a car, bike, etc. but it should be considered as part of real estate, which is an investment. They considered it a consumer product because they have thought a person will live for the whole life. Simply, the investment and financial advisor took it as consumer good but it is an investment in actual.
The consumer product’s point of view, investment or financial advisors encouraged many house owners to lend their house for purchasing of consumer goods. But in actual, when the prices of the houses declined then they (homeowners) have more than what they have before. Consequently, in the financial crisis, many people lost their homes. Some left home while others filed for bankruptcy.
Asset Allocation and Investment Diversification
After reading the questions should arise in your mind that how much of quantity should one have from each class of asset? The answer is no single investment, the best diversified.
It depends on your well-being, with different levels of risk, your aims, objectives, goals and your situation in life. For instance, bonds are riskier as compared to stocks in the current situation, and your aim is to get more within few years, than you should go for holding more stocks than the one who could hold them for 7 years, as investors allocate their investments in different assets and hold a mix of bonds, stocks, and commodities. Therefore, how many much one asset should have in your asset allocation strategy will be purely depending upon your objectives and goals. Consequently, when you are developing your asset allocation strategy you should consult or discuss with a financial planner.
You must also change the balance according to the current phase of the business cycle. In the initial phase of recovery, small businesses give the best. They recognize early opportunities and react faster as compared to larger companies. The stocks of the larger companies yield good profits in the last part of the recovery because these companies have more resources to outrank the small businesses from the market.
You should be aware of asset bubbles, which means the price of an asset or a class of assets rises rapidly. The prices are on the high side because speculators keep bidding up regardless of underlying real values. In this case, regular rebalancing protects you. It is recommended or suggested that someone should sell every asset from the portfolio, which has grown up and consist of a large share of the whole portfolio. The benefit of this strategy is you will never be much affected when the bubble bursts.
As mentioned earlier, the main characteristic of diversified investments or portfolio is that the main asset does not correlate with other assets. During financial crises, the commodities and stocks showed significant correlation. Further, it has also been noted that the international markets and US equities are also strongly correlated. Therefore, if someone has US stocks then no diversification benefit he will enjoy to have developed the market in his portfolio because developed markets move in the same way as stocks do.
The vanguard research showed that US treasury or T-bills have a negative correlation with US stocks. If you want to minimize the risk regardless of returns than the best way to hold both US treasury or T-bills and US stocks because if one harms you others will benefit you. But if you are interested in higher rate returns or profits than this should not be your strategy.
“The vanguard research found that the diversified portfolio consists of all the above-mentioned classes provide the best return.”
Is Mutual Fund a Diversified Investment?
An index fund or mutual fund offers more diversification as compared to a single security. These funds track group/collection of bonds, stocks, and commodities. The index fund or mutual fund would also call as diversified investments if it consists of all six asset classes mentioned above. These assets should be balanced by keeping in view of your goals and objectives, then it would adapt according to the phase of the economic cycle.
How to Diversify your Investment: Pro Tips
1. Expand your Money
Stocks can be wonderful, but it is suggested to do not invest all of your money in the same sector or stock. Simply, do not put all of your eggs in the one basket. You should create your mutual funds which could be based on stocks of different but trusted companies.
But stocks are not the only thing to keep in mind. You can also invest in Real Estate Investment Trusts (REITs), commodities, and Exchange Traded Funds (ETFs). Think beyond and become global and do not restrict yourself to one country. By following this rule, you spread your risk, which yields higher returns.
It is suggested that do not go too far in investments where you fall into the trap for having more and more, which may cause harm. Make sure to stick to a manageable portfolio. It makes no sense to invest in 100 different stocks if you have neither the time nor the resources to follow it. Try to limit yourself within the bracket of 15 to 25 investments.
2. Keep Increasing the Portfolio
Complete your investments regularly. If you need to invest $ 50,000, use the average cost estimate in dollars, which is sometimes known as dollar-cost averaging. This approach is used to offset the ups and downs caused by market volatility. The idea of this strategy is to reduce the risk of investment by investing the same money over time.
By adopting dollar-cost averaging, you have to invest in a specific portfolio of securities regularly. You will buy fewer shares when prices are high and more when prices are less.
3. Review Bonds or Fixed Income Funds
You may consider adding fixed-income funds or index funds to the composition. Investing in a variety of indices is an excellent long-term diversified investment. By adding more fixed income solutions, you can extra protect your portfolio against the uncertainty and volatility of the market. These funds seek to replicate the performance of broader indices. Instead of investing in a particular sector, they try to reflect the value of the bond market.
Another bonus of these funds is that they have low fees, which means your pocket will have more money. Administrative and operating costs are minimal as these funds can only be managed with low costs.
4. Keep Bird Eye View on Commissions
If you are the one who does not understand the trading well then you have to understand what you get against the fees you pay. Some companies charge a transaction fee while others charge a monthly fee. These can reduce and add up your profits.
Pay attention to what you pay for and what you get for it. Remember that the cheapest choice is not always the best. Stay abreast of your changing fees.
5. Take Decision on Time
Dollar-cost average, buying, and holding are good strategies. But, you have not to ignore the forces at work just because you invest in autopilot.
You should stay abreast of changing market conditions and informed about own investments. You have to know what is happening to the companies in which you invest. In this way, you can also determine when it is time to reduce your losses, sell them and continue your next investment.