An article written by Ray Calleja: Head – Private Clients, MeDirect
In this article, we will talk about diversification – what it is, and what role it plays when building a mutual fund portfolio.
So, diversification refers to choosing different classes of assets with the objective of maximising the returns and minimising the risk profile. The strategy involves spreading your money among various investments in the hope that if one loses money, the others will make up for those losses.
You could consider owning different types of funds to diversify your investment and to mitigate risk. Certain types of investments will do well at certain times while others less well. But if you have enough variety in your portfolio, it is pretty likely that you will always have something that is performing relatively well. Owning different types of funds or securities can help reduce the volatility of your portfolio over the long term.
Let us say that you have a value fund that owns a lot of cyclical stocks, which are stocks that tend to do well when investors are optimistic about the economy. If that is the only fund you own then your returns will not look very healthy during a recession, when demand for such stocks is low. If you decide to buy a fund which invests in defensive stocks, such as in food and healthcare company shares, then you would be diversifying your portfolio of funds. And by owning that second fund you are trying to limit your losses during an economic downturn.
Having a diversified portfolio does not mean you will never lose money and diversification does not provide complete protection from market crashes or short-term dips. Diversification also does not guarantee that if one asset class falls the other asset classes will not also goes down.
Although diversification has earned its place as one of the most important rules of investing, it often seems to fail to protect during a market crash. That’s because in volatile times like we experienced earlier this year, historical correlation patterns break down and prices for asset classes that once moved more-or-less independently fall together.
John Petrides, a portfolio manager with Tocqueville Asset Management, comments, “The period we’re seeing now is similar to the 2008-2009 financial crisis where we saw volatility pick up to the point where all asset classes outside Treasury bonds, cash and gold correlating to one.” He explains, “There are many reasons why that happens, including panicked selling in riskier areas of the market, but also investors selling less risky assets in order to meet margin calls (where a broker sells off your assets to satisfy the conditions of the loan on a margin account). Those kinds of factors can drive all asset classes to move in a similar downward direction.” 1
Diversification can occur at several different levels of your portfolio.
Diversifying across the same type of investment - Say you owned shares in a single company. If the company did well, so would your investment. But if the company went insolvent, you could lose all of your investment. To reduce your dependence on that single company, you buy shares in four or five other companies, as well. So, even if one of your investment goes bad, your overall portfolio won't suffer as much. By investing in a mutual fund, you're getting this same protection.
Diversifying by Asset Class - The three main asset classes are shares, bonds, and cash. Some people contend that real estate, investment trusts, emerging-markets equities, and the like are also asset classes - but the higher level classes of equities, bonds, and cash are the most broadly accepted. Adding bonds and cash (typically considered to be financial assets such as bank accounts with maturities of one year or less) to an equity-heavy portfolio lowers your overall risk. Adding shares to a bond - or cash-heavy portfolio increases your total-return potential. For most investors, it is wise to own a mix of all three. How you determine that mix depends on what your goals are, how long you plan to invest as well as your tolerance and capacity to risk.
Diversifying by sub-asset Classes - Within two of the three main asset classes - stocks and bonds - investors can choose several variances of these investments. With equities, for example, you may distinguish between U.S. and other developed market stocks, and emerging-markets stocks. Furthermore, within your developed markets equity allocation, you can have large-growth, large-value, small-growth, or small-value investments. You can also make investments in specific sectors of the market, such as healthcare or technology. The possibilities for classification are endless.
As just discussed, a mutual fund also allows for diversification between various styles, sectors, and countries. You can either buy a mutual fund that is broadly diversified, or you can buy a portfolio of different mutual funds across various sectors and create your own diversification.
While mutual funds are great tools for diversification, you need to avoid the common mistake of putting money into different mutual funds, which are, however, investing in a similar type of or even the same holdings. Like that you are not actually diversifying because if something affects the securities in one fund, it will also affect the other fund. Different is therefore not always the same thing as diverse. Consider which holdings the index you're investing have and try to spread your money throughout different types of mutual fund categories. Mutual funds invest in other assets, too, such as bonds, cash, or commodities like gold and other precious metals, which allows for further diversification.
While it is possible to invest in just one fund, investors are wise to construct their own portfolio and manage it according to their specific needs whether on their own or with the help of an investment advisor.
There is a portfolio theory, which is a common and time-tested portfolio design called Core and Satellite, where you have the "core", which will usually be a large-cap stock fund, which would also represent the largest portion of your portfolio. You would then build around the core "satellite" funds, which will each represent smaller portions of your portfolio. For example, for someone with a moderate (medium) risk tolerance the asset allocation would be 65% equities, 30% bonds and 5% cash. As commented above, the equity allocation can be further sub-divided into large-cap value and some large-cap growth equities from developed markets (mainly US, major European and the Middle East as well as the Pacific countries such as Japan, Australia, Canada etc) with smaller amounts allocated to mid- and small-cap equities and emerging markets (the 10 big Emerging Markets (BEM) are Argentina, Brazil, China, India, Indonesia, Mexico, Poland, South Africa, South Korea and Turkey. Other major emerging markets include Egypt, Iran, Nigeria, Pakistan, Russia, Saudi Arabia, Taiwan, and Thailand). In terms of your bond allocation you may consider government bonds, which are the safest, as well as corporate bonds, which offer a greater return, but you also have a bigger risk that they can default. That is especially true for high yield bonds. As an investor you have the option to invest domestically or look at international bonds, including emerging markets, either by investing directly in such bonds or through mutual funds, which obviously provides much better diversification.
Diversifying across investments and by asset class is crucial. Put simply, diversification is spreading risk across different types of assets, including equities, bonds, and cash. As we have explained, mutual funds make it easy to do this. Diversification remains an essential strategy for investors, especially in times of heightened economic uncertainty and market volatility, like we are experiencing now. In a COVID-19 world, it’s difficult to know which sectors and companies are going to come out ahead. A well-diversified portfolio will be one of the best hedges against that uncertainty.
In other words, do not put all your eggs in one basket. Diversify.
1 Bobbie Turner, ‘The Role of Diversification in Uncertain Times’, thinkadvisor.com (18 May 2020).
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