How does diversification benefit investors?

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Funding Souq Editorial Team
Tech Writer
Mar 07, 2023
Funding Souq’s editorial team comprises experienced finance and investment professionals that are on a mission to fuel SME growth, create jobs, and drive the economy forward. They aim to share their extensive experience and industry know-how to empower entrepreneurs and investors alike.
Mar 07, 2023
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Diversification refers to the strategy of distributing your investments across various asset classes to limit your exposure to any single type of asset, with the aim of decreasing the overall volatility of your portfolio in the long term.

 

Achieving successful investing involves striking a balance between your risk tolerance and investment horizon. If you're too conservative with your retirement savings when you're young, you face two risks: first, the growth rate of your investments won't keep up with inflation, and second, your investments won't accumulate to the required amount for retirement. Conversely, investing too aggressively when you're older could expose your savings to market volatility and erode the value of your assets at a time when you have fewer chances to recover your losses.

 

To strike a balance between risk and return in your investment portfolio, one strategy is to diversify your assets. This involves spreading your portfolio across multiple asset classes in various ways, with the fundamental concept of reducing risk and volatility. By diversifying, you can potentially minimize the frequency and intensity of unsettling fluctuations in your portfolio. However, it's important to note that diversification cannot guarantee a profit or protect against losses.

 

The four main constituents of a diversified portfolio.

 

Domestic stocks, which constitute a more aggressive section of your portfolio, offer a potential for higher long-term growth. However, the likelihood of increased growth comes with a higher risk, particularly in the short run. Due to their inherent volatility, stocks are generally more unpredictable than other types of assets, which means the value of your investment in a stock could decrease by the time you decide to sell it.

 

Bonds, in general, offer a steady stream of interest income and are typically less volatile than stocks. They can also serve as a buffer against the erratic fluctuations of the stock market, as they often have different performance patterns. Investors who prioritize safety over growth may prefer to invest in US Treasury or other high-quality bonds while reducing their exposure to stocks. However, such investors might have to accept lower long-term returns, as many bonds, especially high-quality ones, generally provide lower returns than stocks over the long run. However, it's worth noting that some fixed-income investments, such as high-yield bonds and certain international bonds, may offer higher returns, but come with increased risk.

 

Short-term investments comprise money market funds and short-term certificates of deposit (CDs). Money market funds are a low-risk investment option that provides stability and easy access to your capital, making them an excellent choice for investors looking to safeguard their principal. Nevertheless, in exchange for this level of security, money market funds typically yield lower returns than bond funds or individual bonds. While money market funds are usually considered less risky and more conservative, they are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) in the same way as many CDs are. On the other hand, investing in CDs means sacrificing the liquidity generally offered by money market funds.

 

* Investing in a money market fund can result in losses. While the fund aims to maintain the value of your investment at $1.00 per share, it cannot guarantee it will succeed. The fund may charge a fee when you sell your shares or temporarily restrict your ability to sell them if the fund's liquidity falls below the required minimums due to market conditions or other factors. Investing in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Fidelity Investments and its affiliates, the fund's sponsor, are not legally obligated to provide financial support to the fund, and it's not advisable to anticipate that the sponsor will provide financial support to the fund at any time.

 

International stocks are stocks issued by companies located outside the United States. They often have different performance patterns than US stocks, which could provide access to investment opportunities not found in US securities. If you are seeking investments with potentially higher returns but higher risk, adding some foreign stocks to your portfolio could be worth considering.

 

Other elements that can make up a diversified portfolio

 

Sector funds are a type of mutual fund or exchange-traded fund that focus on a specific industry or sector of the economy, such as technology or healthcare. They invest in stocks of companies within that sector and can be useful for investors looking to take advantage of specific economic trends. By investing in sector funds, investors can potentially benefit from the performance of a particular industry while diversifying their portfolio across various sectors.

 

Commodity-focused funds, investing in commodities can be risky and may require a high level of expertise, but for those willing to take on the risk, equity funds that focus on commodity-intensive industries such as oil and gas, mining, and natural resources can provide a useful way to hedge against inflation. These funds invest in companies that are involved in the production or distribution of commodities, providing exposure to the commodity market without having to directly invest in physical commodities like gold or oil. By adding commodity-focused funds to your portfolio, you can potentially diversify your investments and mitigate the effects of inflation on your overall returns.

 

Real estate funds, which may include real estate investment trusts (REITs), are another option for diversifying your portfolio and reducing the risk of inflation.

 

Asset allocation funds, investors who lack the knowledge or time to build a well-diversified portfolio can consider using asset allocation funds as a single-fund strategy. These funds, offered by Fidelity among other firms, come in various types, such as those managed to achieve a specific target date, maintain a particular asset allocation, generate income, or prepare for certain outcomes, such as inflation.

 

What are the benefits of diversification in reducing the impact of market volatility?

 

 

To mitigate the effect of volatility on a portfolio, diversification is primarily focused on that goal instead of maximizing returns.

 

Theoretically, assume we have portfolios that have different asset allocations. The aggressive portfolio consists of 60% US stocks, 25% international stocks, and 15% bonds. Although the portfolio would have an average annual return of 9.77%, it is deemed to have excessive volatility since its best 12-month return would be 136% while its worst 12-month return would have a loss of almost 61%. This level of volatility may not be suitable for most investors to bear.

 

By slightly adjusting the asset allocation, the impact of market volatility on the portfolio can be reduced without compromising long-term performance. An example of this is a portfolio with 49% US stocks, 21% international stocks, 25% bonds, and 5% short-term investments, which had an average annual return of around 9% over the same time period, but with a smaller range of highs and lows. However, note that adding more fixed-income investments to a portfolio may slightly lower long-term return expectations but can significantly minimize the effect of market volatility. This is a trade-off that many investors are willing to make, particularly as they age and become more risk-averse.

 

Taking into account the time horizon of your investments is an important consideration when implementing a diversified investment strategy.

 

Although people usually think about their savings in terms of specific goals like retirement, college, or a vacation, it is important to consider two critical factors while building and managing your asset allocation. Firstly, it's essential to determine your time horizon or the number of years until you need the money. Secondly, you must assess your risk tolerance regardless of the objective you are pursuing.

 

Suppose your objective is a long-term goal like retirement, which is 25 years away. In such cases, you might consider taking on more risk to achieve long-term growth, given that your time horizon is relatively long. You might assume that in the event of a short-term market downturn, you would typically have time to recover lost ground. Therefore, a higher percentage of domestic and international stocks in your portfolio could be suitable.

 

Your risk tolerance plays a crucial role in your investment strategy, regardless of your time horizon. Even if you have a long-term goal like retirement, you should only assume a level of risk that you are comfortable with. If you are more conservative, you may want to consider a more balanced portfolio with some fixed-income investments, even for long-term goals. Additionally, regardless of your time horizon or risk tolerance, it may be wise to include a fixed income component in your portfolio to help minimize overall volatility.

 

It is important to keep in mind that your time horizon is not fixed and will change over time. For example, if your retirement is now just 10 years away instead of 25 years, you may need to adjust your asset allocation to reduce your exposure to high-risk investments and increase your investment in more conservative options such as a bond or money market funds. This can help reduce the impact of market volatility on your portfolio, which is crucial when you expect to use the money in the near future.

 

As you retire, it's important to shift a significant portion of your portfolio into lower-risk investments that can produce income. However, even during retirement, diversification remains important for risk management. The biggest risk in retirement is running out of money, so it's wise to never be fully invested in stocks and to have some exposure to growth-oriented investments to counteract inflation and help your assets last throughout your potentially long retirement. Additionally, you should not put all your assets into short-term investments if your time horizon is longer than one year.

 

No matter what your objective, your tolerance for risk, or the length of time you have, a diversified portfolio serves as the basis for any prudent investment plan.

 


Image Credit: Photo by Jakub Żerdzicki on Unsplash


Disclamer:
The post is for educational purposes only and the Firm does not directly or indirectly provide these services. Funding Souq KSA is regulated by the Saudi Central Bank (SAMA). This communication is not directed at or intended to be acted upon by any Person in the DIFC.

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