Looking for More Recommendations About Factors to Consider for Diversification of Investments – Read this Article
“Always diversify your investments” – it the common wisdom repeated by the finance textbooks and Investment Advisers. What does the above saying really mean and how to construct an investment portfolio?
Saying it in simple words, it means 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. First of all it is necessary to diversify amongst the different asset classes, such as 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.
To understand it better let’s use the example: 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 because each can perform independently of one another. It should be also mentioned that lately the performance of the metals, energy and soft commodities markets have shown themselves as the ones that can provide formidable returns, independently of the returns of existing asset classes.
Another important thing to understand is that the proportion of each asset class in the portfolio is determined by the risk tolerance of the investor. It means that 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. In this case the significance of volatility is the fluctuation of the asset class’ returns about its mean and it means that an asset with higher volatility can rise higher, but can also suffer sharper falls. After making the decision concerning the proportion of different asset classes in the portfolio, the investor now has to select the components of each asset class.
You should keep in mind that 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. As an example of the composition of a fund of hedge funds buying into a global macro fund, managed futures, a convertible arbitrage fund and a long-short manager could be used.
To conclude it all, the investment community sells the concept of diversification as a way to minimize risk and maximize returns. You should also know that 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. It means that in order to make a decision concerning the level, investor, firstly, has to form an understanding of his/ her risk appetite.
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