Factor-based Diversification: Enhancing Portfolio Stability – Diversification is a risk management strategy that creates a mix of different investments within a portfolio. A diversified portfolio includes a combination of specific asset classes and investment vehicles in an attempt to reduce exposure to any asset or risk.
The reason for this approach is that a portfolio composed of different asset classes, on average, provides the highest long-term returns and minimizes the risk of a single ownership or security.
Factor-based Diversification: Enhancing Portfolio Stability
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks provides the most cost-effective level of risk reduction. Investing in multiple securities generates greater diversification benefits, but does so at a lower level of efficiency.
What Is Diversification? Definition As Investing Strategy
Diversification attempts to smooth out random risk events in a portfolio, so the positive performance of some investments offsets the negative performance of others. The benefits of diversification exist only when the securities in the portfolio are not perfectly correlated—that is, they respond to market influences differently, often in opposite ways.
When investors think of ways to diversify their assets, there are many strategies to implement. Many of the strategies below can be combined to increase the level of diversification within a single portfolio.
Fund managers and investors often diversify their investments across different asset classes and decide what percentage of the portfolio to allocate to each. Each asset class has a different, unique set of risks and opportunities. Classes may include:
Portfolio Strategy Commentary: Diversification
The theory holds that what adversely affects one asset class may benefit another. For example, rising interest rates typically negatively affect bond prices because yields must rise to make fixed income bonds more attractive. On the other hand, an increase in interest rates can lead to an increase in real estate taxes or an increase in commodity prices.
There are huge differences in the way different industries or sectors operate. As investors diversify across industries, they are less likely to be exposed to industry-specific risk.
For example, consider the CHIPS and SCIENCE Act of 2022. This law affects many industries, although some companies are more affected than others. Semiconductor manufacturers will be the most affected, while the financial services sector may feel a small, residual impact.
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Investors can diversify into different sectors by pooling investments that balance different businesses. For example, consider two major forms of entertainment: travel and digital streaming. Investors hoping to hedge against the risk of a major impact from a future pandemic can invest in digital streaming platforms (well-affected by blackouts). At the same time, they can simultaneously consider investing in airlines (less affected by restrictions). In theory, these two unrelated industries can reduce the overall risk of a portfolio.
There are too many variables to consider, and “the exact number of stocks that make up a well-diversified portfolio does not exist.”
Public stocks are divided into two groups: growth stocks and value stocks. Growth stocks are stocks in companies that are expected to grow profits or earnings above the industry average. Value stocks are stocks in companies that appear to be trading at a discount to the company’s current fundamentals.
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Growth stocks are more risky because the company’s expected growth may not materialize. For example, if the Federal Reserve eases monetary policy, less capital becomes available (or more expensive to borrow), creating more difficult conditions for growth companies. However, growth companies can tap into reputedly limited capacity and generate profits that exceed expectations.
On the other hand, value stocks tend to be strong, strong companies. Although these companies may have experienced much of their potential, they typically have little risk. By diversifying into both, an investor can benefit from the future potential of some companies while recognizing the existing advantages of others.
Investors can consider investing in different securities depending on the market capitalization of the asset or company. Consider the key operational differences between Apple and Newell Brands Inc. As of July 2023, both companies were in the S&P 500, with Apple representing 7.6% of the index and Newell Brands representing 0.0065%.
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Each company will have a very different approach to raising capital, bringing new products to market, brand recognition, and growth potential. Low-value stocks have more room to grow, while high-value stocks tend to be safer investments.
In almost every asset class, investors can choose a security’s risk profile. For example, consider fixed income securities. An investor can choose to buy bonds from the world’s top-rated governments or private companies that are close to dying and raising emergency funds. There are significant differences between the various 10-year bonds based on the issuer, their credit rating, outlook for future operations, and existing level of debt.
The same can be said for other types of investments. Risky real estate development projects can fetch higher returns than stable operating assets. At the same time, cryptocurrencies with a long history and widespread use, such as Bitcoin, are less risky than smaller market currencies or tokens.
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Diversification may not be the best strategy for investors looking to increase their income. Consider “YOLO” strategies (you only live once) where 100% of capital is invested in risky investments. While there is great potential to make life-changing money, there is also great potential to lose due to poor diversification.
As with fixed income securities like bonds, different maturities affect the risk profile. In general, the longer the maturity, the greater the risk of declines in bond prices due to changes in interest rates. Short-term bonds have lower interest rates; However, they are also less affected by uncertainty in future yield curves. Investors who are more comfortable with risk may consider adding long-term bonds that pay higher interest rates.
The length of maturity is also prevalent in other asset classes. Consider the difference between short-term residential property leases (ie, up to one year) and long-term commercial property leases (ie, sometimes five years or more). Although there is more security in collecting rental income by entering into a long-term contract, investors are subject to the flexibility to raise prices or change tenants.
How Do Alternatives Fit Into A Diversified Portfolio?
Investors can take advantage of diversification by investing in foreign bonds. For example, the forces that depress the US economy may not affect the Japanese economy in the same way. Therefore, holding Japanese stocks gives the investor a small cushion of protection against losses during a downturn in the US economy.
Alternatively, trading in both developed and emerging countries can result in greater profits (with a higher level of risk). Consider Pakistan’s current classification as a frontier market participant (recently downgraded from an emerging market participant). Investors willing to take on a higher level of risk may want to consider the high growth potential of smaller markets that are not yet fully established, such as Pakistan.
Financial instruments such as stocks and bonds are intangible investments; They cannot be physically touched or felt. On the other hand, tangible investments such as land, real estate, farms, precious metals or commodities can be tangible and have real-world uses. These physical assets have a different investment profile because they can be consumed, rented, built or otherwise handled differently than intangible or digital assets.
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Tangible assets also have specific risks. Real property may be damaged, physically stolen, damaged by natural conditions, or obsolete. Physical assets may also need to carry storage, insurance, or security costs. Although the income stream differs from financial instruments, the input costs for maintaining tangible assets also differ.
Regardless of how an investor focuses on building their portfolio, another aspect of diversification relates to how assets are held. Although this is not an indication of investment risk, it is an additional risk because it can be diversified away.
For example, consider a person with $400,000 of US currency. In all three cases below, the investor has an equal allocation of assets. However, their risk profiles are different:
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The same concept above applies to almost every asset class. For example, Celsius Networks filed for bankruptcy in July 2022. Investors who held cryptocurrency on the exchange were unable to withdraw or transfer funds. If investors were diversified across different platforms, the risk of loss would be spread across different exchanges.
Consider different strategies for dealing with technical risk and physical risk. For example, owning real gold bars and gold ETFs diversifies your portfolio across different risks. If your physical assets were stolen, at least 100% of your gold holdings would not be lost.
Time and budget constraints can make it difficult for non-public investors—that is, individuals—to build a sufficiently diversified portfolio. This challenge is key to why mutual funds are so popular with retail investors. Buying shares in mutual funds provides an inexpensive way to diversify investments.
Important Questions To Ask When Diversifying Your Investment Portfolio
While mutual funds provide diversification across asset classes, exchange-traded funds (ETFs) give investors access to narrow markets, such as global commodities and sports, that are typically difficult to access. A person with a portfolio of $100,000 can spread investments between ETFs without overlap.
There are several reasons why this is beneficial for investors. First, it can be more expensive for retail investors to buy securities using different markets
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