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Diversification is a portfolio risk management technique that mixes a wide variety of investments within an investor portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so the positive performance of some investments neutralizes the negative performance of others.
Therefore, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated, such real estate and stocks.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction.
Those with alternative investments, such as real estate, benefit by adding a portfolio of 25 stocks for further diversification benefits, but also liquidity, 24/ access and transparency to account holdings, current income and possible inflation hedge.For more information or to discuss strategies to decrease portfolio risk, contact Tom Cooper.
Asset Correlation – Why It Is Important Asset correlation is a measurement of the relationship between two or more assets and their dependency. This makes it an important part of asset allocation because the goal is to combine assets with a low correlation to each other. The correlation measurement is expressed as a number between +1 and -1. A zero correlation indicates there is no relationship between the assets. A +1 indicates an absolute positive correlation (they always move together in the same direction). A -1 indicates an absolute negative correlation (they always move together in opposite directions of each other).
Positive Correlation When two or more assets move up and down together. Stocks in the same industry would have a high positive correlation. They would probably be affected similarly by events.
Zero Correlation When two or more assets show no relationship to each other. Combining multiple assets with no correlation, like real estate and stocks, would be an ideal diversified portfolio because volatility (risk) of the whole portfolio would theoretically be minimized. In the real world most assets have some correlation; so a low asset correlation such as between gold and S&P stocks, would be a good example of near non-correlated assets.
Negative Correlation When two or more investments move inversely to each other they have negative correlation. Two assets that were perfectly negatively correlated would eliminate risk of the combined assets.
Please contact Tom Cooper to discuss correlation, risks and diversification themes for you portfolio.
Take the time to study the risks inherent in your investments, in mutual funds and other security products, required disclosures in fund literature can help determine fees, commissions and cost of ownership, along with other points that may help you find if there’s anything amiss that could derail your goals.
But beyond the literature, other basic portfolio risks include:
1. Interest rate risk: Its a good idea to get familiar with a complicated measure called duration, which indicates the sensitivity of a bond or bond fund to a change in interest rates.
The longer the duration — expressed in years, as maturities are, but not the same — the steeper the price decline as rates rise (and vice versa). Unfortunately, high credit quality does not protect you from a plunge in prices of long-term issues.
2. Currency risk: In addition to the risks they share with domestic stock funds, world equity funds pose the risk that a rise in the U.S. dollar’s value against other currencies could cause returns on foreign stocks, expressed in local currencies, to suffer when translated into greenbacks.
3. Investment style risk: Growth-stocks and ETFs are expected to own stocks that can grow faster than an economy, while value stock funds are supposed to buy stocks that sell at discounts to an estimate of their true value. These are called “style” funds.
Owning a growth fund when value funds are hot (or vice versa) — that is, being invested in an out-of-favor investment style, then rushing to an in-favor style leader, and then switching to keep up with style leadership rotation is a recipe for high trading costs and possibly investment losses.
The landscape changes frequently, as indicated by Russell growth and value stock indices, classified according to capitalization. If you believe your portfolio is underexposed to either style and want a growth or value fund to correct that, why not plan to hold it as long as its performance is satisfactory?
4. Unsuitable investment risk: When securities markets offer low bond yields, volatile equity returns, or both, you may be tempted by investments that appear to meet your needs but are in fact unsuitable.
Cash dividends from well-chosen stocks have a good chance of rising over time, but a bond’s payment is fixed till maturity. Moreover, pocketing capital appreciation from bonds would require lower interest rates, which is an unlikely prospect at this point.