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'Asset class diversification is important to reduce portfolio risks.' 'Diversification gives you higher returns.' You will hear investors say this often. Prima facie, it may look like scattering your investments will increase the time and effort in managing them, and performers and non-performers will nullify each other. So how exactly does diversification help in reducing your portfolio risk?
What is an Asset Class?
Asset class is basically a group of similar types of investments. These investments can be broken down into sub-classes by size, industry, location etc.Each asset class reflects different risk and returns characteristics, and performs differently in a particular market. Broadly they are classified into
Equities or Stocks
Equity basically means owning a piece of a company. When you invest in a publicly traded company, you get a stock certificate that indicates how many shares of the company you own, and serves as your proof of ownership. Apart from identifying and investing in the companies you wish to, you need to consider other factors like the purpose you want the returns to serve, or what kind of stock ownership benefits you. In the long-term, stocks are known to earn higher and more consistent positive returns than any other financial investment.
Fixed Income or Bond
A bond is a formal contract to repay borrowed money with interest at fixed intervals. Bonds provide the borrower with external funds to finance long-term investments. Bondholders have a creditor stake in the company, which makes them lenders. Typically, people like to invest in bonds because they pay interest semi annually, providing a predictable stream of income. Invest in bonds if you are looking for the interest income and want to preserve your capital investment.
Cash and Cash Equivalents
A cash investment is a short-term obligation that provides returns in the form of interest payments. It consists of negotiable instruments such as treasury bills, commercial papers and certificates of deposit, and is used by many participants, including companies, to raise funds by selling commercial papers in the market. Investors, who opt for this kind of investment, benefit from its low-risk yield and high liquidity.
Alternative Asset Classes
There are many more alternative asset classes. These include assets like commodities, real estate, precious metals, agricultural land, machinery and oil, international investments, hedge funds, bitcoin etc. People prefer to invest in alternate asset classes for times when the more popular asset classes fail to perform. The flip side to this is that generally, more unconventional the investment, lower the liquidity. This means although the returns on these assets can be liquidated, it might take more time to find a buyer to liquidate them.
One school of thought is more inclined to concentrate on a particular asset class as investments in one asset class exhibits similar characteristics and subsequently tend to have a similar cash flow. This way the investment process is easier to administer. Investors looking for assurance on their returns more than maximising them are inclined towards this idea.
But to maximize returns while reducing the risk on your portfolio, it is important to diversify your asset class.
What is Diversification?
Diversification is broadly defined as a technique that reduces risks by allocating investments among various financial instruments, industries and other categories. Think of it as putting your eggs in different baskets, where each basket reacts differently to a given situation.
Benefits of diversification across asset classes
When you invest in a combination of asset classes, your overall portfolio is less susceptible to suffer during market swings. For e.g. bond and equity markets move in opposite directions. This means if one falls, the other will rise. Allocate your assets by dividing them among the four categories mentioned above (bonds, stocks, cash and real assets). Each asset class has different levels of return and risk, so each will behave differently over time.
The position to avoid is having equal number of investments across all asset classes. This way, you might be prone to performing and non-performing assets cancelling out each other. For this, you need to be very sharp and attentive to the markets and disseminate your money accordingly.
How do I allocate my assets within the asset class?
There is no formula for knowing which asset allocation will guarantee 100% success. But there are a few things to keep in mind before beginning the allocation process:
1) Allocating your assets in high and low-risk stocks, or in short and long-term bonds is more important than which stock or which bond to invest in.
2) Chalk out your life goals before sitting down to allocate your assets. It will help you decide which mix will be beneficial for you in the short and long run.
3) You need to carefully weigh the difference between risk and return in order to become a successful investor. Everyone wants the highest possible return, but simply playing the stock markets isn’t always going to work for you. Always keep an eye on the fluctuating market trends.
4) If you have an existing portfolio, don’t hesitate to revamp it if necessary. There is always time to make new and diversified investments.
5) Do your own research as well instead of relying completely on financial planners. They might put you into a standard plan and not necessarily what is best for you. It is therefore important for you to find an investment advisor who understands the market as well as your needs.
The trick is to have a portfolio that consists of a smart mix of investments, giving you a good opportunity to play safe and take risks at the same time. The more uncorrelated your investments are, the better.
To know more about asset class and other wealth solutions, check out other articles in the series.
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